Drawdown and Maximum Drawdown Explained


As we touched on in the previous chapter, risk management can make you money in the long run if you approach it with a good strategy and patience, but it is not all unicorns and rainbows.

There’s a different side to it too that we will explore further in this blog.

It may not be as pretty, but it is crucial you understand the risks each and every trade can cary.

So let’s say you didn’t use risk management rules.

What could happen?

For example, let’s say you had a $200,000 and you lost $100,000.

What percentage of your overall balance would you have lost?

The answer is 50%. (Plus some hair…)

This is what traders call a drawdown.

Your account has experienced a $50,000 drawdown. 

A drawdown can be defined as the reduction of one’s capital after a significant amount of losing trades.

Or in other words, it is the largest amount you lose before you start making profit again.

drawdown

Let’s explore some of the biggest causes of drawdowns…

  • Poor risk management rules
  • Greediness
  • Fear of losing money
  • Over-trading
  • Trading with too much leverage 

What You Can Learn From a Drawdown 

When trading, us traders are always looking for an EDGE.

After all, it is one of the main reasons why we develop strategies and systems.

Sure, a trading strategy that is 80% profitable sounds like a pretty decent edge to have.

But just because it is 80% profitable, it doesn’t mean that you will win 8 out of every 10 trades.

You could lose the first 20 and win the other 80 trades.

That way, it is still a 80% profitable system but it does raise some questions. For example, would you stay in the game in you lost 20 trades in a row?

drawdown trader

And this is exactly why it’s crucial to have your risk management in place!

No matter what system or strategy you use, you will at some point experience a losing streak. There is no avoiding it. I tried. 

Even the best out of the best forex traders have their losing streaks, and yet they still end up profitable.

Why?

Because they only risk a small percentage of their trading capital.

This is simply what you must do to succeed in such a vibrant and ever changing market. 

Drawdowns are a part of it. Deal with it.

The goal is to come up with risk management rules that will enable you to survive these periods of bigger losses. 

Remember, if you practice and stick to your Risk Management rules, the chances are you will become a part of the 1%.

In the next lesson, we will explore why you shouldn’t risk more than 2% of your account balance.

Click next whenever you’re ready! See you there.