Drawdown forex definition
Drawdown in the finance industry can have two meanings. Drawdown in banking refers to a gradual accessing of credit funds. Drawdown in trading refers to a reduction in equity – how much an investment or trading account is down from the peak before it recovers back to the peak. Drawdown and loss are not the same things. A trader can open position, in one moment make a 2% drawdown and then close position 3% in profit. Profitable closed positions can have drawdown at some moment.
What drawdown teaches you?
A drawdown also helps you to know how long your system of trading can survive in the forex market. Your position may not be defendable if your drawdown is large.
For instance, an investor has to work hard to recover his capital loss if his drawdown is 50%. Even to secure his equity position from breaking he will have to get a 100% profit on the remaining capital.
When a forex trader has a drawdown then the best options for him are to readjust his system and to implement good procedures of risk-management instead of trading aggressively to recover his breakeven point. Usually, the result of the aggressive approach of the trader to recover the breakeven point for his capital can be adverse. The reason behind it can be his emotional decisions, over trading and using leverage to even back his account of trade.
Drawdown can be an absolute drawdown, maximum drawdown, and relative drawdown. In our article absolute drawdown, we described that absolute drawdown refers to the sum difference between the initial capital risked and a minimal point below that level.
Relative drawdown is the maximal drawdown percentage that shows the ratio between the maximal drawdown and the value of respective local upper extremum (of equity).
Relative Drawdown = MaxDrawDown % = Max Drawdown / its MaxPeak * 100%
Maximal Drawdown = Maximum distance (Maximal Peak – next Minimal Peak)
Excessive use of Leverage
Usually, the effects of a bad trade become disastrous if leverage is used excessively by the trader. In fact, traders are not willing to accept a losing trade or have to bear huge losses when they are too confident or too aggressive. According to a trading proverb, our career in a trade cannot be made by one trade but to destroy it one dreadful trade is enough’.
Before entering a trade, to fix a point to stop loss for that trade can be the most vital tip to follow. It will help in reducing the loss due to drawdown. Instead of making emotion-based trading decisions, you should focus on minimizing losses by using strategies to manage risk before doing any exciting trades.
The majority of trades have some kind of drawdown, even profitable trades.