What is a drawdown in Forex, and how should a trader treat it?
Forex trading as an additional or main source of income brings many opportunities for enrichment. For this reason, many people are beginning to be interested in this type of earnings. At first, beginners are enthusiastic about currency deals in Forex, hoping that they will soon be able to increase their income and quality of life. However, not everyone knows that there is such a phenomenon as a drawdown in Forex, so today we will tell you about this economic concept.
By itself, a drawdown is not considered a negative event, as it is part of any trading process and can take place in the practice of both a beginner and an experienced trader. At its core, a drawdown in Forex is a decrease in a trader’s deposit (i.e., trading account) due to unprofitable trading. And although a drawdown is not an extraordinary phenomenon and can occur quite often, it is perceived negatively by the vast majority of traders.
In our today’s material, you will get the opportunity to analyze in detail why a forex drawdown occurs in Forex, what reasons can lead to it, and whether there are ways to minimize financial losses that drawdown inevitably entails. In addition, this article will help you choose the appropriate action algorithm for your situation in order to stop the loss of funds on the deposit and exit unprofitable trades with an optimistic attitude.
Awareness in choosing the optimal Forex trading strategy, understanding how to interact with a broker if the deal is clearly not in your favor, will qualitatively increase your level of preparation for successful Forex trading. Having information about the advantages and disadvantages of the tactics you have chosen, you will be able to identify the essence of the problem, which repeatedly pushed you to make erroneous steps in making deals in Forex.
Types of forex drawdowns by trade status
As noted above, drawdown as an economic phenomenon is relevant to any market, including the securities market. In the context of currency trading in Forex, drawdown has its own specific features, in particular, drawdown is divided into 2 main categories, which are useful for a trader to remember. So, depending on whether the position is still open or already closed, the drawdown is divided into the following types:
2 main categories:
- current (or floating) drawdown;
- fixed drawdown.
It would seem that the division of just a couple of varieties should not cause difficulties in perception, however, there are subtleties here too. For example, the current drawdown is not subject to final assessment until the trade is closed. In this case, the drawdown in Forex has the potential for both decrease and growth. When trading dynamics change, there is a possibility that the drawdown will become zero, and the trade will go into a plus.
Of course, this is an extremely desirable scenario for a trader, but no one can guarantee such a course of events, so you need to be mentally prepared for the fact that the drawdown will only increase. If the deal continues its unprofitable dynamics, then it makes sense to forcibly stop trading in Forex. Loss of a deposit demotivates the trader, and to prevent this from happening, one should avoid excessive impulsiveness when choosing a strategy, especially for aggressive Forex trading strategies.
The second type of drawdown is called a fixed drawdown. As the term itself suggests, this means that the position has already been closed, and losses can be calculated with high precision. Any floating drawdown in Forex turns into a fixed drawdown over time due to the fact that the deal will be closed one way or another. The fixed drawdown can be regarded as a useful analytical tool, because the trader has all the necessary data to critically review his own actions.
Types of drawdowns in Forex by type of trading strategy
In addition to the classification of drawdowns in Forex described above, there is another convenient typing associated with the strategy a trader chooses to trade in Forex. A multifaceted and comprehensive analysis is always more informative and meaningful than an examination of the issue from only one angle. So, drawdown in Forex differs not only in the status of the position (floating / fixed), but also in the type of strategy. As a rule, these differences are revealed at the backtesting stage, therefore they are distinguished:
- relative drawdown;
- maximum drawdown;
- absolute drawdown.
The relative drawdown in Forex is expressed as a percentage of the trader’s losses. For example, instead of indicators in a certain currency, for example, in dollars, the drawdown will have a percentage value, which also comes in handy when measuring a specific percentage of losses. In such a situation, a trader can get a clear idea of the operations that provoke drawdown in Forex. The exclusion of such a trigger step will help stabilize the state of the deposit.
The maximum drawdown in Forex is similar to the relative one, however, it is expressed not in percent, but in monetary indicators. The maximum drawdown shows the size of the maximum losses for the trader’s account in relation to the maximum profit achieved. That is, the most contrasting, peak value, which determines the maximum level of unprofitable Forex trading. Do not be intimidated by these numbers, but it is better to thoughtfully analyze what actions could become a catalyst for such a scenario.
Absolute drawdown in Forex shows the maximum amount of losses for a trader’s deposit, but the difference from the previous type is that the whole period of backtesting a trading strategy in Forex is taken as a basis. If we consider an example, then we can assume that initially the trader had $ 20,000. During Forex trading, the account did not decrease below the $ 19810 mark. Thus, the difference between the default (initial) amount of the deposit and what it became after a losing trade does not exceed $ 190. That is, the absolute drawdown in Forex is equal to this amount, which, in principle, is not bad at all.
Is it possible to reduce the drawdown level in Forex?
Of course, this problem is very relevant today among all categories of Forex traders. Everyone strives to reduce the level of drawdown, but not everyone knows how to achieve this. It is not uncommon for such commands from the brokerage company as Margin Call and Stop Out to lead to large drawdown indicators. The essence of the Margin Call is the requirement of the broker to deposit additional funds, otherwise it will not be possible to make a deal.
Such a requirement does not arise without a good reason. If in the course of the transaction the funds on the trader’s deposit are rapidly decreasing, then the replenishment of the account by the trader becomes a guarantee of reliability for the broker. However, this step does not always help to avoid destructive consequences for your deposit. The broker can also use the Stop Out command, which will forcibly close either part of the deals, or even all deals on your account, if the drawdown in Forex continues to grow.
Again, these broker’s sanctions themselves should not be regarded as the end of your career as a trader. It is much more important to pay attention to your own actions that force the brokerage company to resort to such extreme measures. As you know, Forex trading always involves a high degree of risk and, as a result, psychological pressure on your nervous system. It is common for traders to lead themselves to bankruptcy without any outside “help”, so there’s no one to blame.
A decrease in the level of drawdown in Forex is possible with careful control of money management. The drawdown is directly proportional to the risk: the higher you expect to profit from a trade, the larger the hypothetical drawdown can be. So that the drawdown in Forex does not become something shocking and repelling for you from further trading activities, then the following principles will be used as reasonable behavior, which we will list below:
- using the Stop Loss command;
- placing Take Profit;
- maintaining common sense when choosing the amount of leverage.
The Stop Loss command, as its name suggests, is designed to help the trader limit the amount of losses. If you do not use it, but rely on your intuition or professional skills, this can play a cruel joke with you, and the deposit will begin to melt before our eyes. Correctly placed Stop Loss orders can literally save you from a fatal drawdown in Forex and contribute to a smooth, gradual increase in your profit from deals. In addition, it makes sense not to resort to overly “assertive” trading tactics.
If you set Take Profit correctly, you will be able to take your profit from Forex trading before the critical moment when the price reverses and the deal will definitely turn into a losing one for you. This is a good strategic move that insures the trader from unexpected troubles. Drawdown in Forex in this case will be minimal, and you will have chances of further continuation of profitable trading with a lowered risk level correspondingly.
As for such a tempting auxiliary tool as leverage, before coming to any definite decision regarding the choice of the amount, the trader must think in detail about all the consequences of his erroneous actions. It should always be borne in mind that the larger the leverage, the higher the risk of a significant drawdown in Forex trading. Accordingly, it is better to choose a reasonable amount that will not destroy your deposit if the transaction is unprofitable.
Summing up our today’s review, we want to emphasize how important it is when making deals in Forex to maintain a logical attitude, carefully calculate your every step and not treat a drawdown as something unexpected or demotivating, since it is a natural trading phenomenon. A rational approach to choosing a Forex trading strategy, a preliminary analysis of your actions and backtesting a drawdown before starting real trading will help you increase your income.