Lesson 3: What Is the Drawdown in Forex?

In the previous lessons, we've talked about the importance of risk management in keeping your capital at the optimal level. With a properly managed risk, your trade and your capital have a fighting chance to profit from the high-stakes and dynamic forex market. 

Now, let's look at the more serious side of trading: when your trading capital is in a drawdown. 

In its most basic form, a drawdown is expressed in percentage, representing how big of an impact a series of losing trades has on your trading capital. 

Lesson Highlights 

• A drawdown is the difference between your capital peak value and its through value. It represents the reduction of your capital or trading account value over a period of capitalization. 
• When discussing drawdown, the peak represents your account's highest value. Conversely, the through indicates the lowest capital value before it recovers or appreciates.  
• Poor risk management, emotional trading, over-trading, and using too much leverage are among the biggest causes of capital drawdown.  

What Happens When Your Trade Risks Left Unmanaged? 

The forex market is risky—that is not rocket science to all forex traders and enthusiasts.  

The moment you let the market risk take over your trade position, you must expect a substantial loss coming your way. 

However, a trade in a risky environment doesn't always equate to a losing trade. Remember, risks are the end of it all. If you manage the risk, you can be safe while trading on the forex market. 

One way to ensure you manage the market risks properly is by measuring and monitoring your capital drawdown.  

Capital in Drawdown: What Does This Mean? 

In forex trading, a drawdown refers to the reduction in the value of your trading capital or trading account. In other words, this represents the amount your trading capital has been losing by showing you the peak-to-through decline of your trading account during a specific capitalization period.  

Note: A drawdown is usually expressed as a percentage and indicates the severity of a trader's losses. However, some trading platforms audit drawdown in USD.  

Okay, so a drawdown is an indication that your trading account is losing, but what more does this tell you? 

Aside from telling you that you're losing, it also shows the health of your trading portfolio and its survivability. 

Remember, a drawdown doesn't always have to be bad. Remember that risk is native to online trading; thus, a drawdown is just a common experience for every trader. All you must do is act on it to protect your capital and maximize the potential returns.  

Drawdown Terms: Peak and Through 

Before you can effectively manage your trading capital, it's essential to be familiar with these two drawdown key terminologies: your capital peak and through. 

Understanding these terms helps you evaluate the performance and risk associated with your trades and strategies. 

Peak

When talking about drawdown, the term peak represents the highest value that your trading account has reached before a drawdown occurs.  

Say you started off trading with a USD 10,000 account. After gaining $500 off your few trades, your trading equity is now USD 10,500. With this scenario, your account's peak is USD 10,500. After a few bigger trades, you've run at few losses, costing you USD 1,000. These unfortunate losses make your account decline to USD 9,500. 

In this case, your account's peak value is USD 10,500.  

Through

When talking about through in the context of drawdown, we're talking about the lowest value your account has reached during the drawdown period before it begins to appreciate or recover.  

Let's look back at the previous example: 

Your capital is USD 10,000, with a peak value of USD 10,500. However, your account declined to USD 9,500 after a few losses in the forex market. Now, you've tried again, but the market still moved against your positions, making you lose USD 500 more and dropping your account equity to USD 9,000.  

After a few more market analyses, you placed other trades, and their direction ended up riding the market movement. You gained USD 1,250 with these trades, and your trading account rose to USD 9,750.  

With this, your capital through value is USD 9,000.  

How to Calculate Drawdown 

To calculate how much drawdown your capital has, you simply get the difference between the peak amount of your trading account and the current, losing amount. After that, you divide the difference by your account's previous peak.  

This formula gives the drawdown as a percentage, indicating the extent of the loss relative to the peak value. 

Assume your trading account has a balance of USD 5,000. After placing a few trades on the market, you've incurred a USD 1,000 loss. Due to your unprofitable trades, your balance dropped to USD 4,000.  

Now, let's calculate your account drawdown considering these given values: 

Previous Peak: USD5,000 

Current Through: USD4,000 

DD= [(PP – CT) / PP] x 100% 

DD= [(5,000 – 4,000) / 5,000) x 100% 

DD= (1,000 / 5,000) x 100% 

DD= 0.2 x 100% 

DD= 20% 

Again, calculating your drawdown can give you an important reference for evaluating your trading plans and strategies. If your strategies or plans keep on putting your capital on a drawdown, tweaking or entirely changing them is advisable as it indicates their low performance in the market.  

While a drawdown is part of trading and is not something you need to get sweat off, it's still best to avoid increasing your capital drawdown risk. Here are the four big causes of capital drawdown:  

1. Poor risk management 
2. Emotional trading 
3. Over-trading 
4. Too much leveraging 

Trading is inherently risky because of its volatility. However, staying informed and rational pre-, during, and post-trading is the best route to keep your capital at the most optimal level.