In this article we will look at 5 strategies you can use to handle drawdowns in your forex trading account. Firstly we’ll make sure we’re all on the same page by discussing what drawdown means, then we’ll provide 5 tips on how to minimise.
Next we’ll look at when drawdowns occur and how we can better understand what our trading system’s drawdown is before finishing up with some tips on how we can manage or minimise our drawdown value.
So let’s get started by exploring:
What does drawdown mean?
Drawdown is the percentage difference from the highest value to it’s next lowest value. When calculating the drawdown value across our peak and trough points in our portfolio we use the highest value.
Let’s illustrate what we mean by using an example. We’ll assume in January at the beginning of the year, that our portfolio hit an account balance high value $550. Then February comes along, and our account balance hits an account balance low of $490. From these two values we can now calculate our drawdown value, as so:
1 - (490 / 550) = 10.91\%
Let’s further continue in March and say that our portfolio account balance shot up to a new high of $600. Lastly, let’s state in April our account balance went back down to $515.
What would our drawdown be?
As our portfolio achieved a new high in March we would use this value going forward, and as our next month exhibited a low we would use this value to calculate our drawdown value, like so:
1 - (515 / 600) = 14.17%
As our latest drawdown calculation is greater than our first drawdown calculation (10.91%) we would say that our portfolio drawdown is the larger value being 14.17%. As the calculation of drawdown covers every period since the portfolio started trading.
As this example has shown, a large percentage number is not a good value. Our objective should be to try and keep our drawdown value as small as possible.
What does drawdown of 100% mean?
Now that you know the theory of how drawdown is calculated you might easily be able to answer the question above.
Let’s tease this out a little more using our working example:
- What would the drawdown value be if our portfolio in May was $300?
- What would the drawdown value be if our portfolio in May was instead at $50?
If your answers to the above 2 questions were: (1) 50% (2) 91.67% you would be correct.
But did you notice the trend?
As our portfolio value diminishes in value our drawdown value increases.
Therefore, a drawdown value of 100% would be a complete wipeout of our trading account. And we definitely don’t want to trade a system that will cause us to lose everything we put in!
When do drawdowns occur?
Now we have some idea about what drawdown is let’s put our heads together and try to figure out a way where we can minimise it in our portfolio.
Drawdowns occur when either of the following events happen in our trading system:
- Our total losers and larger than our total winners (in dollars);
- We experience a large dollar loss or a string of losses.
Knowing when they can happen will not be as meaningful as knowing when they’re likely to occur with your system.
So how can we know when they’re likely to occur?
There are two ways which are quite popular, both involve time, and depends on your aptitude:
- Back-test your forex trading system and analyse the drawdown from your backtesting software; and/or
- Demo trade your forex trading system and see how it performs using “live” data.
If you’ve got the ability the first option would be the quickest way in seeing how your system’s drawdown performs over time, but this will require obtaining and downloading historical forex data.
The second option is chosen by most new forex traders as it’s an easy way to dip your toe in the water without getting wet.
However, seeing the drawdowns your system has historically made will only help you to know if your current drawdown is average or abnormal. This may either help you manage your emotions, or completely freak you out.
So this leads us to our final query – how can we handle or minimise drawdowns?
How to handle drawdowns
Here are five tips you could look at implementing (or backtest) with your trading system to see if it lessens the drawdown figure:
- Cut losses quicker
- Use profit targets
- Widen stop losses
- Use a second account
- Change position sizing method
Tip #1 – Cut Losses Quicker
One way you can look at reducing the impact of drawdowns is to cut losses quicker. Every big loss started out as a small loss, and it may be a case of adding some form of time stop to trades if they’re not behaving in a certain way.
Think about it. Your entry into a currency pair is due to a particular view you have about the market. Is your view to wait 2 weeks for the market to move there? Then why not wait?
Perhaps you could look at taking small losses until the market eventually confirms your view and takes off.
Tip #2 – Use Profit Targets
Remember that drawdowns can occur if our total losses are greater than our total wins.
Could your trading strategy use a profit target? Do you find your system going in the right direction, but turning quickly against you?
Could you look at implementing a trailing strategy once the currency pair has started becoming profitable? Or perhaps once it’s achieved a level of profit?
Tip #3 – Widen Stop Losses
If you’re finding the number of losses is increasing and therefore totalling more than the wins, could it be that your stop loss is too tight?
Are you using a static stop loss, like 50 pips for all currency pairs? How does this work for volatile currency pairs like the GBPJPY which can easily move 50 pips in a matter of minutes?
Perhaps your entry method and your exit strategy aren’t in proper alignment. Look at testing what would happen if you used some form of technical stop like a low price point, or an ATR stop.
Tip #4 – Use a Second Account
What can cause lots of problems with our forex trading account is maintaining the margin and at the same time trying to manage our open losing positions.
One method that could help your broker exiting your trades early due to failure to have enough margin in your account is to open a second account for new trades, while leaving the other account to manage open losing trades until those trades have closed.
We will be looking at this strategy in a little more depth in a subsequent post. Stay tuned!
Tip #5 – Change Position Sizing Method
Another more practical method that is relatively easy to implement in your trading system is to change the number of trading lots you do when in a drawdown.
Yes, it does mean it may take longer to get out of the drawdown, but at least you’ll survive to trade another day rather than being wiped out.
Therefore, as an example, if you trade a standard lot for each trade and are currently exhibiting a drawdown, then look to reduce your trade size by 20-30% and see how your system performs. You could also look at increasing your trade size during purple patches when your trading system is doing well.
Hopefully this article has been helpful if you’ve found some of these tips useful, or if you have more you’d like to share let me know in the comments below.