Drawdowns are a normal part of trading, but understanding them and knowing how to handle them can make all the difference in a trader’s success. If you’re trading with a prop firm like Falcon Funded, managing drawdowns is crucial because prop firms typically have strict loss limits in place.
In this article, Falcon breaks down answers to the question, ‘What is a drawdown in trading?’ and offers tactics advanced traders can use to use drawdown to mitigate risk.
What Exactly Is a Drawdown?
A drawdown in trading refers to the reduction in the value of your trading account after a losing streak.
It’s the difference between the highest point of your account balance (the peak) and the lowest point it drops to (the trough) during a losing period. Think of it as the gap between the highest and the lowest points after a series of losing trades.
Drawdowns are inevitable, and every trader faces them at some point. The key is how you manage them when they happen.
How to Calculate a Drawdown
Calculating a drawdown is straightforward. Here’s a simple formula:
Drawdown = (Peak Account Balance – Trough Account Balance) / Peak Account Balance
Let’s say your account balance peaks at $10,000. After a series of losses, your account drops to $8,000. The drawdown would be:
($10,000 – $8,000) / $10,000 = 0.20, or 20%.
This means you’ve experienced a 20% drawdown in your account.
When evaluating drawdowns, it’s important to understand the different types and what they reveal about your strategy or portfolio. Here are the main types of drawdowns:
Maximum Drawdown (MDD)
Maximum Drawdown is the biggest drop in your portfolio from the peak to the trough over a certain period. MDD shows you the worst-case scenario for your strategy or the most you could lose at once, helping with managing risk and setting expectations.
Average Drawdown
Average Drawdown looks at the average size of all the drawdowns in a specific timeframe. It shows you how much your account typically drops and how volatile your strategy is. Frequent or deep drawdowns point to overly risky tactics.
Relative Drawdown
Relative Drawdown is the size of your drawdown compared to the highest point your account has reached. It shows how severe the current dip is compared to your peak. This helps you understand how much of your gains you’ve lost and how deep the drawdown is compared to where you started.
Drawdown Risk Management
Some prop firms have automated risk management tools, like margin calls or automatic stop-loss orders, that can help protect your account if you hit certain drawdown thresholds. However, if those tools aren’t available, it’s up to you to manage your risk when you hit your drawdown limit.
Here are some powerful risk management techniques:
- Limit Risk Per Trade: Only risk 1-2% of your account balance on each trade. This way, a series of losses won’t wipe you out.
- Use Stop Losses: Always set a stop loss to automatically close a trade if it goes against you. This helps prevent larger losses from turning into major drawdowns.
- Set Daily Loss Limits: Prop firms like Falcon Funded have loss limits in place. You can set your own daily loss limit (e.g., 2% of your account) to avoid overtrading when things aren’t going well.
By implementing these risk management strategies, you can reduce the likelihood of large drawdowns, but when they do occur, there are valuable lessons to be learned that can help you become a better trader in the long run.
Using Drawdowns to Your Advantage
Drawdowns are something every trader will encounter, but they don’t have to hold you back. In fact, they’re valuable learning experiences. By understanding how drawdowns work, you can use them to adjust your strategy and achieve long-term success.
If you’re ready to put your trading strategy to the test with real capital, sign up with Falcon Funded. Start a prop firm challenge today.
