One of the main terms in Forex trading is the ‘drawdown’. A lot of traders include this feature to perform better, and to improve their trading strategy.
In this article we’ll explain what a drawdown in Forex is, how it’s calculated and how it can influence a trading strategy.
Meaning Drawdown Forex
The drawdown in forex is the capital reduction that a trader has after a series of losses.
Every trader, during their trading activity, will experience losses as well as winnings.
What is important to analyse though, is how much those losses reduce the capital.
In order to do that a monthly analysis of the trading statement is essential.
Usually it is between the 20% to the 40%. Anything above 40% means that there are some issues with the trading strategy used.
To calculate the drawdown, it’s necessary to take the highest pick before the losses and calculate the difference with the first lowest one after it.
Here’s an example:
If a trader reached the maximum amount of $10.000 in their account, and afterwards they have a series of losses. If these losses are touching the $8.000, it means that the drawdown is 20%.
$10.000 – $8.000 = $2.000
Drawdown= (2.000 * 100)/10.000 = 20%
This is the formula to use for the calculation.
If in one month there’s an important drawdown happening, it means that the selected trading strategy should be reviewed.
Trading Strategy – Drawdown forex
When we talk about reviewing a trading strategy in order to reduce the drawdown, we mean that a trader should analyse their money management.
The money management represents the amount of money to use in each trade to avoid complete capital losses.
The rule is that for each position, a trader should risk maximum the 5% – 10% of their capital.
This means that with an account of $10.000, for each trade, the user should invest and risk a maximum $500.
Following this strategy can help traders to minimize the financial risk involved in trading.
Drawdown Forex & Diversification
We’d recommend that you follow this strategy whether you’re an experienced trader or not. That’s because minimising losses is as important as making profits in forex.
If you follow this example we’ve provided, you should also remember to trade with different positions.
For instance, if a trader wants to open 3 positions, they should divide the risk between these 3 positions.
Taking again the example of the account with $10.000 and risking the 5%, the $500 should be divided across the 3 trades. That means that for each position the trader should invest $166.67.
By using this strategy, the risk is under control, and applying diversification across the trades is key. Doing this helps to risk even less capital and avoids the possibility of a big drawdown.
Conclusion Drawdown Forex
At the end of this article, hopefully it’s clear what the meaning of drawdown in Forex is.
The worst drawdown that a trader can have is a 100%, because this means the trader lost all their profits made in the past.
Generally all traders can face a drawdown, but the average is between the 30% to 40%.
Avoiding big losses is essential. That’s why having a good trading strategy, or following good money management is essential.
The psychological aspect is also very important, it’s good to know that you are in charge of your trading and that there are tools to help you. One important tool that is always worth using is a stop loss.
For instance, when a stop loss has been set up, there is no need to worry about losing all the capital in the account. A stop loss will automatically close a trade when it reaches your selected exit price.
Focusing on a suitable trading strategy and using tools like the stop loss will help you to limit any drawdown amount you may make.