What is Forex Drawdown and how to control it?

In forex trading, drawdowns refer to the difference between a high and low point in your account balance. Understanding drawdown is just as vital as understanding margin, leverage, currency pairs, and other standard terms in forex. In this article, we look at exactly what drawdown in Forex trading is and discuss how to control it in order to prevent losses.

What is a Drawdown in Forex Trading？

Drawdown is an essential part of Forex trading and is a valuable metric to determine the health of your trading portfolio. Knowing how to control it will help you have a successful trading career. A drawdown (DD) in forex trading refers to the percentage of the money you have lost from your trading account balance when making a particular trade.  

A forex trader experiences a drawdown when losing equity on their account in a trading period. It is the amount that has been drawn from your account following the losses in forex trading. You will not face a drawdown unless you lose money on the trade. 

A drawdown is bound to happen sooner or later, no matter what strategy you use to trade forex. In the forex market, you experience a drawdown whenever your balance declines. 

For example, lets say you open a currency trading account with $50,000. Following a bad trade, you see your account equity drop to $45,000. In other words, your account has been hit by a $5,000 drawdown. 

Remember that a drawdown is part of trading, and you cant avoid it, but you can keep it under control. A successful trader comes up with a trading plan that allows for withstanding periods of losses through applying solid risk management. A trading plan which is 70% profitable seems very good to have. It means that you can encounter a 30% loss while keeping the overall trading activity 70% profitable.

How to Calculate Forex Drawdown？

A drawdown is a measuring tool commonly used by all types of investors, including forex traders, in order to determine the potential risk involved in an investment. Forex traders typically use the drawdown function to monitor the performance of their trading strategies. 

The drawdown is usually shown as a percentage (%) and is plotted over time to show change over time. It represents a loss or potential loss in the value of an investment, usually after a series of losing trades. Due to its direct link to performance and risk management, many forex traders use drawdown as a tool to identify weaknesses in their trading strategy. 

Drawdown Formula

Below is a statistical formula for calculating the drawdown amount or % of a specific investment or portfolio.

Where: 

• D(T) = Drawdown Time 

• t = Peak 

• T = Trough 

• X = Variables 

Drawdown Example:

For a simple explanation of how drawdown is calculated, lets say, for example, you have a $10000 trading portfolio. The equity in your account drops to $8000 after a bad trade or a losing streak. 

Answer: You lose $2000. The account decreased from $10000 to $8000 reflecting a 20% decrease. 

10000 (Peak) – 8000 (Through) = (2000 ÷ 10000) × 100 = 20%

Best Strategies to Control a Forex Drawdown

All types of trading can result in a drawdown, and failing to recognize and learn from them will only result in more difficulties and losses. A forex trader should never underestimate the importance of controlling drawdowns. It is necessary to remain profitable. 

The following are the best strategies forex traders can employ to control drawdowns: 

• It‘s critical to learn how to deal with the psychological turmoil associated with drawdown. It’s crucial to maintain positive trading psychology to make better decisions.  

• Try reducing trade size or leverage. Leverage is a double-edged sword, as it increases both profits and losses. Holding positions for longer periods exposes a portfolio to market risks and can cause drawdowns. 

• A guaranteed stop-loss order (GSLO) can also reduce drawdown. By using GSL orders, you can ensure that your stop loss will be executed without slippage at the desired price. 

• Setting a daily loss limit also minimizes the losses on a single day. Once you reach the daily loss threshold, you need to stop trading for the rest of the day and only resume trading the following day. 

• Place a stop-loss directly on your account balance. Traders might also want to make use of an account equity stop loss in addition to traditional stop-loss mechanisms. If this stop is triggered, all open positions will automatically be closed at market price.

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