When it comes to forex trading, the term “drawdown” refers to the difference between the highest point in your trading account balance and the next lowest balance point. The difference in your balance reflects the capital lost due to losing trades.
What You Can Learn from Drawdown
Drawdowns also describe the potential capability of your system to survive in the long run. A large drawdown puts the investor in an untenable position.
Consider this: a client experiencing a 50% drawdown has a huge task and a real challenge ahead because they need to achieve a 100% return on their reduced capital to reach breakeven in the diminished equity situation.
Many investors or fund managers on Wall Street feel happy if they achieve an average profit of 20% per year. As can be imagined, when a trader experiences a drawdown, they are better served by implementing good risk management practices and resetting their system rather than trying to trade aggressively to strongly recover the breakeven point.
An aggressive approach by the trader to recover capital and breakeven usually has the opposite outcome. Why? They are likely to become emotional, using leverage and overtrading to restore the trading account to its initial state.
Excessive Leverage
Most traders use leverage to open positions because it can be very difficult to do so with cash. Problems arise when a trader uses excessive leverage. It becomes hard to recover losses and maintain your margin, not to mention the possibility of losing your entire account in seconds.
There is an old trading saying: One trade rarely makes your trading career, but a single bad trade can definitely end it.
When traders use excessive leverage, it can have catastrophic effects – and it often does. After incurring a loss, traders tend to become more aggressive and take on more risk. This usually leads to significant losses or an unwillingness to accept a losing trade that should be cut.
Recommended Reading
The book “What I Learned from Losing a Million Dollars” by Jim Paul and Brendan Moynihan offers some excellent insights if you want to read a book describing the emotional burdens of drawdowns.
The book discusses how a trader lost his career and large sums of his family’s wealth and friends’ money due to experiencing a significant drawdown.
The book also shares many tips on overcoming some common trading mistakes, such as executing a trading plan that may be emotionally driven rather than risk-managed.
Final Thoughts
One of the most important pieces of advice you will hear is to set a stop-loss or market stop order for each trade before entering. This will limit the amount of any drawdown you may incur. Avoid making trading decisions based on emotion. Instead, focus on a strategy that relies on risk management by exiting trades early enough to minimize losses.
Once you take these steps, you will be able to stand aside after entering a trade, knowing that you are out of it without question when your stop-loss level is hit.
Many traders make the mistake of trying to stay in a losing trade, hoping for a turnaround. This is a mistake because you will make your trading decisions based on emotion rather than strategy. By staying in a losing position, you are doing the least painful thing you can do. However, it may not necessarily be the most beneficial in the long run.
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Source: https://www.thebalancemoney.com/what-is-drawdown-1344949
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