Stay Calm And Deal With The Drawdowns In Forex

Aug 24, 2020 10:36 PM ET
Stay Calm And Deal With The Drawdowns In Forex

Traders who are going to stay in the game have to be aware of the string of losses and the down periods that threaten their trade account balance. Understanding drawdown and what traders can do to safeguard their capital from being wiped out is one of the most important lessons for any trader, especially if they are looking to trade forex for a long period of time.  

The Forex Inevitability: No one likes drawdowns

The difference between a high point and a low point during a specific period for your trading account investment is a drawdown. As the name suggests, it reflects the capital lost due to losing trades. There are two types of drawdowns that traders should be familiar with, absolute and relative drawdown. 

Chart drawdown

Absolute Drawdown

Absolute drawdown is the difference between the initial capital risk and the slightest point under that level. It measures the initial risk that is involved in the investment and tells you the size of your potential loss while trading in relation to the capital risked. 

Absolute drawdown is used by those who are not so much concerned with measuring performance as they are with bringing returns. 

Relative Drawdown

This type of drawdown is for traders who are concerned with their performance efficiency. It indicates the amount that traders can risk compared to their initial investment. This is because it highlights the maximum drop in equity percentage and not the absolute amount.

If you’re trading forex, you are bound to go through a losing streak, and insofar as that is true, a drawdown is inevitable. But, that doesn’t mean that one has to crash and burn during a drawdown. The best traders know how to minimize the effects of a drawdown and ensure that they land softly. 

A drawdown provides important clues and hints as to the likely survivability of your system over the long run. A big drawdown will put a trader on shaky grounds. Most traders when they suffer a drawdown become emotional and look to get their capital back through an aggressive approach. But, this only ends up having the opposite effect as the trader ends up over-trading their account. 

During a drawdown, the best approach is to implement a good risk-management strategy and readjusting the system, instead of having an aggressive approach to get back to the breakeven point.

How to deal with it?

You must have a set process firmly in place if you want to control the drawdowns. It could be considered as a disaster mitigation plan for your forex trading. Here are a few tips for dealing with a drawdown and losing streaks.

Keep Risk Low

You are going to come across a drawdown period at some point in your forex trading career, and if you are in this business for long, you’ll have at least one severe drawdown. 

Keep Risk Low

That is why you should not risk more than 1% to 2% of your trade balance per trade. Find out what 2% of your account balance represents and only go in for a trade if you’re willing to lose that amount on the next trade.

Minimize risk if losses continue

The second tip that you should consider is to minimize your risk if losses continue. A trading slump brings about three choices in front of a trader. The first is to stick with the same risk amount per trade. This is not the worst option but it is also not going to help you much. 

The second option, which is also the worst of the three and what most traders are guilty of, is ‘revenge trading.’ In a bid to recover their losses, traders either maintain their level of risk or increase their risk. If you are guilty of this, your account is going to be empty before you know it. 

The third and the only sensible option is to reduce your risk level for every subsequent loss. This will ensure that you maintain a healthy trade balance even after a drawdown period. Once you have had two to four winning trades and regained your confidence, you can start increasing your risk level again. 

Establish a drawdown cap 

Every trader goes through a tough period when they are off their game. During such periods, if a trader wants to prevent the losses from piling up, it is best to set a monthly or weekly cap. For instance, if you lose 5% of your trading account balance after a few losses, you have to stop trading until the next month begins. Of course, adjustments are always welcome depending on the trader’s style, such as setting a weekly cap instead of a monthly cap. 

Early signs for a forex trader

Early signs for a forex trader

Drawdowns occur randomly in the market and cause temporary periods of loss. Unfortunately, neither fundamental nor technical analysis can allow traders to predict the forex market. However, if you are experiencing losing trades in a row especially after a peak, be prepared for an emerging drawdown. 

During such periods, it is important to mitigate the drawdown risk by ensuring that you have a well-diversified portfolio. You should also know the length of the recovery window, given the size of the drawdown. Most financial advisors maintain that for a person who is early in their career or is still more than 10 years away from retirement, a drawdown limit of about 20% is enough to keep the portfolio safe for recovery. 

Final thoughts

During a drawdown, the number one rule is to protect your capital at all times for which you should: 

  • Diversify your portfolio

  • Set up caps on your drawdowns

  • Reduce trade risk

  • Quit for some time

Don’t make the mistake of increasing your risk when you are suffering losses. Taking a hit in forex trading is part of the game. It is a necessary expense that traders should be ready to endure if they are going to find profitable trades. But, these expenses need to be controlled and proper strategies need to be utilized if traders want to keep trading forex and not have their balance wiped out.

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