Fluctuations are a common occurrence in the financial markets. Prices move up and down as traders react to various news, developments, and economic releases. The fluctuations lead to traders making profits, as others incur losses equally. Drawdown is an important occurrence as prices fluctuate in the market.
A drawdown is how much an account has fallen from its peak to the lowest level or trough. It is a percentage of declines in the value of the underlying security over a period before bouncing back to the original level. Consequently, it is expressed as the difference between an asset's highest peak and lowest trough values.
Source: Wallstreetmojo.com
The value is often calculated as a percentage. Its calculation lets investors know in advance the risk associated with trading a given asset, therefore, plan accordingly for the future. The concept is relevant in various sectors, including banking, mortgage, stock, market and forex trading.
Contrary to perception, a drawdown is not a loss. It is simply the movement from a peak level to a trough. The drawdown will not amount to a loss if the market bounces back from the trough to the peak. Therefore, it is possible to suffer a big drawdown followed by a significant bounce back, resulting in price powering through the previous peak.
The formula for calculating drawdown is straightforward. It entails taking the maximum or the highest value of the trading account or the investment portfolio and the minimum value and subtracting. Then, the resulting figure is divided by the maximum figure and multiplied by 100 to get the percentage drawdown.
Source: Squareoff.in
Drawdown = Pmax-PminPmax X 100
Pmax Historical high (Peak)
Pain Historical low (trough)
A trough can only be defined once a new peak is arrived at in the trading account.
Consider a trader with $100,000 in a trading account who decides to trade the EURUSD pair in the forex market. While the pair can be extremely volatile as traders react to various economic and geopolitical developments, the risk of losing with one trade is usually high.
Now consider that after two weeks of trading the EURUSD pair, the trader's initial capital drops to $80,000. In this case, the loss of $20,000 amounts to a 20% drawdown.
Drawdown = 100000-80000100000 X 100 = 20%
It is still possible to suffer a significant drawdown but remain profitable in the market. For example, let's say you have $100,000 invested in the forex market. After a series of trading, the account grows to $150,000, translating to a profit of $50,000 from the invested capital.
However, afterwards, you experience a series of losing trades resulting in the trading account dropping to $125,000. While you are still profitable with $25,000 in gains, the account would have suffered a drawdown
Drawdown = Pmax-PminPmax X 100 = $150,000- $125,000$150,000 X 100 = 16.7%
The 16.7% drawdown does not amount to a loss of 16.7% but rather a pullback from the new peak to the recent trough
It is important to measure drawdowns as it signifies the amount of effort or price change required for a portfolio or trading account to bounce back to its initial peak. Investors watch drawdown keenly as it influences the kind of trades they take afterwards and whether they may require adjusting their trading strategies.
Source: Comparableforexbrokers.com
For instance, a drawdown of 1% is quite low as the trader will only need to gain 1.01% to bounce back above the previous peak. Therefore it will call for moderate measures regarding changes to trading strategies and the kind of trades one takes in the market.
On the other hand, a drawdown of 50% is quite significant as it amounts to losing half of the trading account capital. Therefore, one will require 100% gain to overcome the drawdown.
Drawdowns help traders better understand the turbulence in the market, which influences their trading decisions in the long run. For instance, the longer it takes for an asset to stay below the peak price, the more likely a lower trough could result in a larger drawdown amount.
Every forex trader needs to know how to assess drawdowns effectively to mitigate the risk most of them pose. In the forex market, drawdown is mitigated by diversifying the trading account. Therefore, instead of trading highly correlated currency pairs, one can trade pairs that don't always move in the same direction.
Consequently, one could trade major, minor and exotic currency pairs. However, focusing on the major currency pair as they are highly liquid increases the trading risk for significant drawdown, partly because the pair's price action is always a factor in the US dollar action. Therefore diversifying the portfolio across different currency pairs can help mitigate and reduce the drawdown risk.
The recovery window is another vital aspect to consider while reducing the drawdown risk in forex. The recovery window will always vary depending on the type of assets one trades. In most cases, it takes much less to recover drawdowns in CFDs markets involving forex than in trading instruments such as stocks and bonds.
The measures to mitigate drawdown risk could involve changing an entire trading strategy or reducing the stake amount in each trade. One can also resort to using tight stop losses or avoiding trading volatile assets to reduce the risk of significant losses.
For instance, if a trader has set a maximum 15% drawdown if the drawdown reaches the 10% threshold while trading, they could reduce the lot size traded. But on the other hand, they could avoid assets considered too risky.
Leveraging the drawdown tool in forex trading helps a lot in various ways.
Drawdowns keep traders on their toes over potential risks associated with trading various instruments that could result in the invested capital being wiped out. Therefore they can prepare themselves accordingly.
Studying historical drawdowns allows traders to clearly understand their trading patterns and strategies and whether they are working. Therefore, they strive to remain within the maximum drawdown level without being overly aggressive or conservative.
Drawdown trading allows traders to make investment decisions while considering the risks of trading the various instruments. If they are still determining whether they can bear the losses that might come with trading a given instrument, they can skip them in advance.
Relying on a fixed drawdown value can be detrimental when trading various instruments in the market. Given the volatility disparity, the value must always change when trading stocks, forex or commodities.
A drawdown level may be hit by a short-term development, such as negative news or political stories that trigger extreme volatility over a short period.
The temporary phenomenon may cause one to close positions only for the market to bounce back once the dust settles.
Additionally, a drawdown presents a significant risk considering the uptick that might be required to overcome a drawdown.
Source: Comparableforexbrokers.com
For example, while a 1% drawdown would require only 1.01% to recover above the previous peak, a drawdown of 20% would require a 25% return, while a 50% drawdown would require a 100% increase.
Drawdown is a valuable trading tool as it allows traders and investors to assess the extent of risk associated with trading a given instrument. Factoring in the amount of loss one can bear or manage, it becomes much easier to make trading decisions.
There is no specific drawdown that works for all traders. It depends on the trader's risk tolerance and the trading account size. An aggressive trader with a big trading account can tolerate a much higher drawdown of upwards of 20% and still be comfortable trading.
On the other hand, a conservative trader would be better off with a lower drawdown. Nevertheless, in most cases, drawdown should always be at most 20% if one is to trade with peace of mind and avert the risk of being wiped out.
The best way to reduce drawdown in forex trading entails diversifying the currency pairs one trades. Instead of trading the major currency pairs, one can also trade minor currency and exotic pairs to spread the risk. Additionally, one can reduce exposure to volatile assets that fluctuate significantly. Reducing leverage in CFD trading can also keep drawdown low, as leverage is a double-edged sword that magnifies losses.
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