If you’re a trader, then you need to know about drawdown and maximum drawdown. These concepts are essential for risk management and ensuring that your trading account remains healthy. In this post, we’ll explain what drawdown and maximum drawdown are, and how you can use them to your advantage.
What is a Drawdown in Trading?
Drawdown in trading is the reduction of a trader’s capital after a series of losing trades. It’s normally calculated as the difference between the peak high in your capital balance and a relative low of your account balance. Usually, it is expressed as a percentage.
Here’s an example:
You start a trading account with $10,000. You quickly lose $2,500. What is your drawdown? Easy… 25%. You drew down 25% of your account.
Though it may seem like a technical term at first, drawdown is an important metric to keep in mind when trading on the market. It measures the largest difference between a peak and a trough during a particular period of time. Taking into account your drawdown can help traders identify if they are taking too much risk, or if their strategies are likely to succeed in the long run. Knowing what your maximum drawdown looks like can help you make smarter decisions about when to make trades, as well as how much capital to invest in them. However, it does not necessarily guarantee success.
What is a Maximum Drawdown in Trading?
The maximum drawdown is the total amount that you can drawdown your balance. If you have a self-funded trading account, the maximum drawdown of your account would be 100% — meaning you could lose all of the capital, if things don’t go your way.
The terms maximum drawdown or maximum trailing drawdown are often used in the context of a funded trader program offered by a prop firm like SurgeTrader. These programs offer traders capital with which to trade, but, in order to protect the firm’s capital, these accounts are subject to a maximum drawdown — or the percentage of the account balance that can be lost before the trader is disqualified from the program.
A maximum trailing drawdown means that the drawdown limit moves up as the trader earns profit in the account — trailing the increasing account balance.
SurgeTrader’s Maximum Trailing Drawdown Explained
Here at SurgeTrader, our Maximum Trailing Drawdown is the maximum a trader’s account can drawdown before breaching their account. The initial level is set at 5% from the starting balance of the account. As the account balance increases, the trailing maximum drawdown follows the trader up until they achieve a profit target of 5% in the account. Once a trader has achieved a 5% profit target, the trailing drawdown is removed and traders can draw back down to their initial starting balance before breaching the account.
This means for profitable traders, the maximum trailing drawdown can be greater than 5%.
Here’s an example:
Let’s say you have a $100,000 account. You can go down to $95,000 before being disqualified. You are a profitable trader and make $4,000 in your account. Your High-Water Mark is now $104,000 (balance, so just closed trades). Your maximum drawdown limit will be $99,000. Next, you make an additional $1,000 in your account. So, your new High-Water Mark is $105,000. Here is where it will lock in, so as your High-Water Mark rises your max drawdown limit will stay at $100,000, which means your maximum drawdown increases beyond 5%.
Let’s say you grow your account to $120,000. Your effective maximum drawdown level is now 20% (4x greater).
Here’s a brief video to help explain the concept:
Drawdowns are Normal
Drawdowns are normal in trading, but you should be aware of them nonetheless. Drawing down in trading is a normal part of the process, but it should still be taken seriously.
Think about a pro poker player, as an example. Professional poker players go through stretches where they have losing streaks, yet they remain profitable in the long run because they have a winning strategy. Not only that, but they are not risking their entire bankroll on a single session or tournament.
The same applies to trading the markets. Even if you are consistently profitable, you will have losing streaks. It’s part of the game. Just make sure you have enough capital and that you aren’t risking too much of your bankroll, to weather those losing streaks.
It’s important to remember that if your account experiences drawdown losses, it’s not necessarily a sign of a bad strategy. There are always risks that come with trading the markets. The key is understanding those risks and adopting a well thought-out trading plan to minimize them. Taking stock of what your trading plan dictates and how much you can tolerate in terms of drawdown can help manage potential losses in your account balance.
Manage Your Emotions in the Midst of Drawdowns
Be careful not to let your emotions get the best of you when experiencing a drawdown in trading — it’s important to stay calm and focused.
It’s easy to get stressed when our trading accounts aren’t performing as well as we’d like them to, but it’s important that we don’t let our emotions control the decisions that we make. Emotional charges during times of drawdown can lead us to rash trades, foregoing our strategies and plans in the name of making quick gains. If this happens often enough our overall trading performance will suffer significantly in the long run. This is why it is so important to maintain a level head and remember why we are in the markets in the first place; proper risk management techniques and consistent strategy execution help us to achieve success while employing discipline and patience.
Disclaimer: All information provided here is intended solely for study purposes related to trading financial markets and does not serve in any way as a specific investment recommendation, business recommendation, investment opportunity, analysis, or similar general recommendation regarding the trading of investment instruments. The content, in its entirety or parts, is the sole opinion of SurgeTrader and is intended for educational purposes only. The historical results and/or track record does not imply that the same progress is replicable and does not guarantee profits or future profitable trading records or any promises whatsoever. Trading in financial markets is a high-risk activity and it is advised not to risk more than one can afford to lose.