Different definitions of drawdown
Many people who begin to think about running their own business or trading activities in Forex currency exchange are interested in such a concept as drawdown. Nevertheless, there are often cases when discrepancies of this term are allowed, which leads to a not entirely correct perception of this economic phenomenon. In our today’s review, we will introduce you to two definitions of drawdown, after which you can easily correctly understand the meaning of this word depending on the context.
Banking and Forex trading are undoubtedly interconnected. Commercial and central banks often participate in Forex trading, but in the banking environment drawdown implies a completely different state than in exchange trading. The key difference between drawdowns in banks is the borrower’s gradual access to credit funds. It should be noted that such a finance distribution can be divided into certain stages and issued as needed.
When it comes to a loan, drawdown in banks affects both individuals and companies alike. It would be useful to emphasize the aspect that a drawdown in such situations can perform a protective function in relation to both the borrower and the credit institution itself. Below we will explain why the bank drawdown should not be considered a negative phenomenon and what practical benefits it can bring to both parties of credit obligations.
How to regard drawdown in banks as a positive phenomenon? The essence of the bank drawdown protective mechanism is that such an algorithm for accessing credit funds allows the borrower not to overpay extra interest on the loan. If a person needs some amount for the certain project implementation, for example, treatment or repairs, then the bank has the right to provide the borrower with money based on evidence of the expediency of these actions.
Impact of bank drawdowns on individuals and companies
So, from the hypothetical situation we have mentioned, we can conclude that drawdown in banks has positive properties for the borrower. But, probably, not all the audience of our blog will agree with this thesis. Does drawdown really have a positive effect on the state of the borrower’s account, if we mean an individual? There is a category of people who would like to receive all the loan funds at once, without any phased payments.
Let’s see how rational this desire is. It can be assumed that a certain individual is planning to carry out a complex and multi-stage project, for example, the complete restoration of a dilapidated country house. From the estimate drawn up for all stages of repair and construction work, it follows that, most likely, this person will have to contact the bank in order to obtain a loan, since they do not have enough money for this. Why doesn’t the bank issue the entire loan amount at once?
In this case, the bank drawdown will only benefit the borrower, since they will not have to receive money, the use of which cannot be found at this stage of the project. In addition, receiving the entire loan amount will automatically increase the borrower’s debt to the bank, and, therefore, the person will have to pay higher interest for the amount that they are not even using now. It is logical to assume that it would be more reasonable for the average individual to operate with a bank drawdown mechanism.
Banks tightly control the issue of borrowed funds. Naturally, only the availability of supporting documents will allow you to get the next part of the loan. The same is true for legal entities. Drawdown in banks also manifests itself in that case if any organization expresses a desire to get a loan to perform large-scale work. Again, an example is a large enterprise (factory, construction company), which is allocated money for the implementation of a project as a separate stage is completed.
Drawdown in trading and the traders’ attitude towards it
And now we suggest to consider another definition of drawdown, which any Forex trader must have heard often in the context of currency trading. So, we have analyzed in detail what drawdown in banks is. What is the concept of drawdown in trading? As mentioned above, the bank drawdown should be treated neutrally, not perceived as something negative, because it can carry a number of positive consequences for the borrower.
However, the majority of traders, hearing about a drawdown in Forex, feel annoyance and other not the best emotions. What is the reason for this? It is known that drawdown in the field of currency trading implies a decrease in funds in a trader’s account, sometimes up to their absolute disappearance. Of course, it is rather difficult to develop a stoic attitude towards such a phenomenon, because no trader would want their deposit to literally melt.
Traders with great experience and expert-level analysts argue that a drawdown in trading is an inevitable phenomenon, so you should take it not as a demotivating factor, but as a trigger that makes you think about where you could have made erroneous steps when concluding transactions in Forex. An emotionless, sober approach to a careful study of your mistakes and the wrongly chosen trading strategy can help stabilize your deposit and reduce drawdown in Forex.
To expand the general horizons, it will also be useful to remember that drawdown in trading takes place not only in the Forex currency market, but also in the securities market. For example, when trading stocks, the trader’s deposit can also decrease if this was caused by incorrect actions, initially unprofitable conditions of the transaction, or a turn of events in a direction unfavorable for the trader already in the process of trading. A trade drawdown affects all existing markets and it is up to the trader to minimize it.
Classification of drawdowns in trading
There are several kinds of typifications by which drawdowns in trade are usually classified. Today we will pay special attention to drawdowns in Forex, since understanding the reasons that cause trade drawdowns will help you, if not completely avoid this phenomenon, then at least reduce the number of provoking factors. Systematic observation of your Forex trading style and analysis of the tools used will come in handy to identify the root of the problem.
Depending on the status of the transaction, whether a position is open or already closed, drawdowns in Forex trading are divided into categories such as current or floating drawdown and fixed drawdown. With an open order, it is not yet possible to make a final calculation of losses, it is impossible to be sure exactly how much money will be withdrawn from your deposit upon completion of the transaction. An unpredictable feature of the current drawdown in Forex trading can be called its ability to both increase and decrease until it is completely neutralized.
However, this statement cannot be attributed to a fixed drawdown in Forex trading. Naturally, the current drawdown will become fixed as soon as the order is closed. With any closed deal, it becomes possible to calculate the amount of drawdown in Forex. This is why closed orders are useful, because they help to carry out research work on your entire trading strategy as a whole. You can carefully study the dynamics of the rise and fall of prices, as well as take a critical look at your tactics – what if it is too aggressive in this situation in the foreign exchange market.
And gradually we have come to the classification of drawdowns in Forex trading by the type of the chosen trading strategy. There is a division into three types: absolute, relative and maximum. An absolute drawdown signals the highest, peak loss values since the beginning of the strategy’s backtesting period. A close examination of the absolute drawdown, especially if the strategy is still being tested, is useful for further avoiding mistakes in Forex trading.
The relative and maximum trade drawdowns are similar to each other, the difference is that the relative drawdown is calculated in percentage, and the maximum one – in currency. These drawdowns in trading represent a difference, a strong contrast between the highest earned profits and the largest losses in Forex currency trades. Both of these types of drawdowns in Forex can also serve as an analytical basis for working on your own shortcomings in terms of choosing a trading strategy.
Summing up: should you avoid banking and trading drawdowns?
As mentioned earlier, drawdown in banks does not pose any threat or harm to the borrower. The only caveat is that the credit institution issues money gradually, and not the entire amount at once. For most people, at first, a loan seems like an illusion of financial freedom, and instant access to an impressive amount of money is the dream of many. However, we must not forget that upon receipt of the full loan amount, the maximum debt to the bank will also be issued.
A more sensible solution would be to obtain a loan in stages, which is the essence of the bank drawdown. Therefore, the payment of interest on the funds actually spent preserves and does not increase the borrower’s debt. It is worth agreeing that this is a much more rational approach to lending than a one-time provision of funds. Thus, drawdown in banks is a reasonable measure, beneficial to both the credit institution (since it is more protected from risks coming from the borrower) and the borrowers themselves.
As for the trading drawdown, especially drawdown in Forex, here you need to understand: a decrease in the funds on the trader’s deposit is also a natural event. Another question is how to relate to this and whether it is possible to avoid drawdown in trading completely. Since drawdown in Forex is an element of the trading process, it is unlikely that it will be possible to completely eliminate it, however, with the correct building of a trading strategy in Forex and with its competent organization, there is a high probability of significantly reducing the trading drawdown and increasing the profitability of your transactions.