The Meaning of Drawdown in Forex
Drawdown is the difference between the balance of your account and the net balance of your account. The net balance factors in open trades that are currency in profit or in a loss.
When your account net balance is lower than your account balance, you have what is known as a drawdown. As an example, let's say that a currency trading system begins with a balance of $100,000. It then sees an equity drop down to $95,000. It has a $5,000 drawdown.
What You Can Learn From a Drawdown
Drawdowns also describe the likely survivability of your system over the long run. A large drawdown puts an investor in an untenable position.
Consider this: A client who endures a 50-percent drawdown has a large task and a real challenge ahead of him because he must have a 100-percent return on the reduced capital stake just to break even on the reduced equity position.
Many investors or fund managers on Wall Street are ecstatic with around 20 percent for the year. As you can imagine, a trader who suffers a drawdown is best served to simply readjust his system as opposed to trying to aggressively trade his way back to the breakeven point.
Typically, an aggressive approach to get his capital back to break even will have the opposite result. Why? He will most likely use leverage and over-trade to get his trading account back to even.
Too Much Leverage
When traders use too much leverage, one bad trade can have disastrous effects—and it often does. In short, traders are either too aggressive or too confident, and this leads to sharp losses or an unwillingness to accept a trade as a loser that should be cut. There is an old adage in trading that one trade will rarely make your trading career, but one bad trade can certainly end your career.
What I Learned Losing $1,000,000 by Jim Paul and Brian Moynihan offers some excellent insight if you'd like to read a book that describes the emotional toll of taking a drawdown.
The book discusses how a trader lost his career, significant amounts of his family's fortune, as well as money of his friends by taking a large drawdown.
This book also shares some excellent tips on how to overcome this common pitfall of trading without implementing a plan that is likely to be emotionally driven.
One of the greatest tips is to have a predetermined stop-loss point on your trade before entering. This will limit the amount of any drawdown you will take.
You'll be able to stand back after you've entered the trade, knowing that you're out of it with no questions asked when and if the level is hit.
A lot of traders make the mistake of trying to negotiate with the market as to whether they should stay in the trade.
It's a mistake because you'll be emotionally driven and likely to do the thing that is the least painful at the time but not necessarily more beneficial down the road.