One of the most important things to be aware of when trading forex is drawdown. This determines how far your account balance has fallen from its peak, which can have a significant negative impact on your trading results, discipline and emotions. If you do not try to control it, things can get out of hand and fast. You can avoid getting into such a messy situation when you understand the various ways in which you can reduce your forex drawdown when trading currency pairs.
What is forex drawdown?
A forex drawdown is the reduction of capital after a series of losing trades. This is normally calculated by getting the difference between a relative peak in trading capital minus a relative trough. Drawdown can apply to both open and closed positions. Traders normally note this down as a percentage of their trading account.
How do you calculate forex drawdown?
In forex trading, the drawdown is calculated as a percentage of your account balance. The maximum drawdown formula is the ratio of the all-time equity high and the difference between the all-time equity high and the all-time equity low. Generally speaking, the higher the drawdown, the riskier the forex strategy is.
Forex drawdown example
As an example, suppose that your currency trading account begins with a balance of $10,000. You are using your own forex trading system, and after one bad trade, you see your account’s equity drop down to $9,000. Your account has experienced a $1,000 drawdown, or 10%.
How do you reduce your forex drawdown?
There are a few ways in which you can reduce your drawdown when trading forex. This includes reducing the lot size, using a tighter stop loss and limiting your trade activity. With good forex money management, you can significantly reduce your drawdowns and trade with a potential loss that you can handle.
You could use a smaller position (lot) size. For example, if you were trading 1 standard lot ($10) and had a loss of 10 pips, this would be the equivalent of $100. If you halved your lot size to 0.5 ($5), a 10 pip stop loss would instead be $50 and thus reduce drawdowns.
Of course, using smaller position sizes will also mean that you make less profit on successful trades. You could always spread the risk by using correlated forex pairs or add to your position as it moves in your favour, locking in profits along the way.
Tighter Stop Loss
You could consider using a tighter stop loss on your trades. For instance, if you had a 100 pip stop loss and traded a position size of 0.1 ($1), a full loss would be $100 minus your forex brokerage fees. If you reduced your stop loss to 50 pips, then a loss would be $50 instead.
However, you need to consider whether your chosen trading strategy can still work with a lower stop loss. This is because some forex strategies require a higher stop loss to maintain a higher win rate. What some forex traders do not understand is that you can have a win rate below 50% and still come out on top if you have a good risk to reward ratio.
For example, if you had a stop loss of 100 pips and take profit of just 10 pips, you might have a higher win rate, but 1 bad trade will cancel out 10 consecutive winners. On the other hand, if you had a stop loss of 10 pips and a 100 pip take profit target, you could come out on top with a win rate of just 20%.
The thing is, both a wide stop loss and tight stop loss can cause high forex drawdowns when you think about it. A wide stop loss may not be hit often but can cause a large drawdown when it is. However, if a tight stop loss is hit frequently it can still have just as much drawdown but spread over more trades.
Trade Smart Not Hard
During my many years in the forex industry, I have seen lots of forex traders who try to force trades that are not there. This can be because of greed or anger when they are trying to win back losses. It can also be out of boredom or desperation to try and make as much as possible in as little time as possible. These are all factors that can cause high forex drawdowns.
Instead of trying to constantly buy and sell currency pairs, it might be a better idea to take a step back and develop a good forex trading plan where you can spend less time watching the charts but look for long term trades with good profit potential. This will save you from fighting with the markets all day long, help to eliminate the factors that can cause unnecessary losses and reduce forex drawdowns.
Forex leverage allows you to take position sizes larger than you would be able to without it. Whilst this does mean that there is the potential for bigger wins, it equally increases the chances for bigger losses. Hence, forex leverage is considered a double edge sword that can also cause high drawdowns.
For example, if you have $1,000 in your account, and you open a $100,000 position (which is equivalent to one standard lot), you will be trading with 100 times leverage on your account ($1,000 x 100 = $100,000).
If you took a buy trade on the EUR/USD but it started to move against you and went down 10 pips, you would be looking at a $100 drawdown already which is 10% of your account. The EUR/USD can move 10 pips in minutes!
Therefore, reducing your leverage and trading sensible lot sizes for your account balance can significantly reduce your forex drawdown. This is why so many forex regulators have imposed restrictions on the leverage that forex brokers can offer.
Trade Higher Timeframes
I find that there is a lot of noise on the lower chart timeframes such as the 1-minute, 5-minute and 15-minute charts. This means that you can get taken in and out of the market unless using a wide stop loss which can also increase drawdowns.
If you switch to the higher chart timeframes like the 1-hour, 4-hour and daily charts, you will find that they can to a better job of filtering out some of the forex market noise. This is because there is more price action included in the higher chart timeframes. I also find technical indicators tend to be more reliable and easier to interpret.
Avoid Risky Forex Strategies
I see so many forex robots and forex signals that claim to make high returns but use extremely dangerous trading strategies that more often than not will blow up a trading account. This includes forex grid trading and martingale money management. I would personally avoid these types of forex strategies as they usually end up with very high drawdowns and can cause you to get a margin call.
I think it is better to use a forex system that has some sound trading logic behind it with sensible stop loss and take profit levels. This can reduce drawdowns when compared to the risky strategies above. Yes, they can go on good runs, but the inevitable usually always happens sooner rather than later.
What is a good maximum drawdown in forex?
Zero would be ideal. I know that is unrealistic but we want to try and reduce forex drawdowns as much as possible. A 10% drawdown on a forex strategy that has already made 100% profit might not look as bad as a 10% drawdown in the first trade, but all drawdown is bad in my opinion.
If I had to pick a number, I would say around 10% is acceptable. However, every forex trader has a different risk preference. You should therefore manage your trades so that the maximum drawdown possible is something that you would be comfortable with.
Don’t forget, there can be unexpected “black swan” events that can still cause unexpected losses which you might not be able to control.
Conclusion: can I reduce my forex drawdown when trading?
Yes, you can use all of the methods above to try and reduce your forex drawdowns to a sensible level. I know there are some traders who do not mind high drawdowns if there is a chance of high rewards and that is fine. I just don’t think that is a sustainable way to trade forex in the long term.
I would practice trying to reduce drawdowns on a forex demo account which you can get for free from most forex brokers. This is a good way to improve your trading skills, money management and build up your confidence. Once you have your forex drawdown under control and start seeing some consistent results, you might then consider making the switch to a live account.
Self-confessed Forex Geek spending my days researching and testing everything forex related. I have many years of experience in the forex industry having reviewed thousands of forex robots, brokers, strategies, courses and more. I share my knowledge with you for free to help you learn more about the crazy world of forex trading! Read more about me.