Drawdown is a word that is feared and hated by every trader, but it is an inevitable part of playing the markets. It is simply how much your account loses from its peak.
Suppose you start with $10,000 in your account, and after a succession of losses the account goes down to $7000. That means you have lost $3000, or 30% of the original starting $10,000, and therefore your drawdown is 30%.
Drawdown is relative to where your account peaks, so say you had a good run and built the account up to $12,000, then lost $3000 again, bringing it down to $9000. Your drawdown this time would be $3000 from $12,000, or 25%.
Maximum drawdown corresponds to the lowest your account ever hits. Sometimes you will see trading strategies detailing how much maximum drawdown is expected to be when using them – usually the more risky strategies will anticipate a greater drawdown while expecting a higher profit on average.
Drawdown is particularly dangerous because, the way statistics work, you must achieve a much larger percentage gain to recover to your starting position than the percentage you lost in the first place. In the example above, when your account fell from $12,000 to $9000 you had a drawdown of 25%. However to get back up to $12,000 you would have to make 33% on the money you have left.
If you lose 50% of your starting capital, then you need to make 100% on what is left simply to reinstate your original position. Thus it is easy for losses to run away from you, and if you are not careful you may find it very difficult to get back after a losing streak.
If you have a big loss, it can be tempting to change your tactics, and go big on the next trade that seems to be a sure thing, attempting to make your account back up quickly. This type of response to losses has caused the premature end of many would-be traders’ careers, and you need to avoid it and develop patience to reinstate your account.
This is why experts will tell you that you should risk losing only what seems like a very small amount of your account on any trade, say 2% or 3%. It may seem that this limits severely how much you can win, and therefore slows your progress in building your account up, but the alternative leaves you open to a succession of losses from which recovery will be impossible.
It is also important to point out that, depending what type of trading you do, risking 2% of your account does not mean that you can only stake 2%. Possibly you might stake 10% of your account, with a stoploss that limits your losses to 2%.
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