As we touched on in the previous chapter, risk management in forex trading can make you money in the long run if you approach it with a good strategy and patience. Still, 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 carry. Or, in other words, how to use forex drawdown to better manage the risk in your trading account?
So let’s say you didn’t use risk management rules. What could happen? I mean, there’s always a significant risk of losing money when you trade different asset classes, especially when you are placing trades in volatile markets.
For example, let’s say you had $200,000 in your account balance 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 many traders call a drawdown. Your account has experienced a $100,000 drawdown.
Simply put, a drawdown refers to the reduction of one’s capital after a significant amount of losing trades. It is calculated as the percentage a trader lost from the initial peak value to the new peak (or the low point at the same period).
In a simple explanation, a forex drawdown is the largest amount you lose when trading currency pairs before you start making a profit again in your trading portfolio.
There are several factors that increase your drawdown risk and the downside volatility in a trader’s account. These include:
Beyond that, you should take into consideration that trading is a tough business. Occasionally, even the most successful forex trader can get into a period of ’tilt’, which is a poker term that refers to a situation when a trader is losing control and makes bad trading decisions, and has no trading plan.
In this situation when you experience a large drawdown in your account, there’s a high risk that you will continue your losing streak. Therefore, it is recommended to stop trading and get back into the trading routine when you are more focused and you set aside all the negativity. Also, if needed, you can use a demo account from your forex broker for several days, and get back to forex trading in the real live market when you get your confidence back.
When trading the forex market, we forex traders are always looking for an EDGE. After all, it is one of the main reasons why we develop trading strategies and a trading system. 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 forex trades you make, and thus, a forex drawdown could occur.
Basically, you could lose the first 20 and win the other 80 trades. That way, it is still an 80% profitable trading strategy but it does raise some questions. For example, would you stay in the game of forex trading if you lost 20 trades in a row? Do you think you have the risk tolerance for drawdown periods? And, what’s the drawdown percentage you can take in your account value in order to continue trading and winning trades?
And this is exactly why it’s crucial to have your risk management strategies in place! More importantly, you need to set a maximum drawdown percentage you are willing to risk when you lose money in the markets. This is the most important trading system many successful forex traders use – make sure you have a maximum relative drawdown amount you can lose in one trade, in one trading day, or at a specified period of time.
Because no matter what other trading system or strategy you use, you will at some point experience a losing streak when trading forex, or in general in your trading career. There is no avoiding it. I tried.
Even the best out of the best Forex traders and the most profitable traders have their losing streaks, and yet they still end up profitable. Why? Because they only risk a small percentage of their initial capital, meaning they analyze drawdown risk in their account balance and use the right relative drawdown percentage to protect their trading account in times of high market volatility in financial markets or at times when they are not trading well.
This is simply what you must do to succeed in such a vibrant and ever-changing market. Ensure you have a maximum drawdown amount of your trading capital and always follow this rule.
The bottom line is that your goal is to come up with risk management tools and a trading system that will enable you to survive these periods of bigger losses. Whether you are planning to focus on forex trading and trading CFDs, or you plan to focus on the stock market trading stocks and mutual funds- setting up a maximum drawdown could help you manage how much money you are willing to lose in each bad trade.
Remember, if you practice and stick to your absolute drawdown rule, the chances are you will become a part of the 1%. You need to be aware of your risk tolerance, and accordingly set an absolute drawdown amount to manage the risk in forex trading
In the next lesson, we will explore why you shouldn’t risk more than 2% of your account balance and learn how to effectively manage a losing trade. Click next whenever you’re ready! See you there.