What is Drawdown -How to Control It?

Many novice traders fail because they cannot withstand the pressure of market instability. They cannot afford it because they lack self-control and do not develop appropriate risk management strategies. One of the first things you should learn is how to control your losses. Avoid letting it get in your way and you'll be a more successful trader.

What is Drawdown?

Withdrawal is the decrease in the balance of the trader's account from the peak. It specifically refers to the reduction of the total value of the trader's account from the highest price to the lowest price within a given period of time. This decline reflects the losses incurred in the course of the transaction.

For example, suppose the trader's initial trading account balance is $ 10,000, and the account balance drops to $ 8,000 after a series of trades. In this case, the loss would be $ 2, 000. The $ 2, 000 decrease represents losses incurred during the trading period.

There are five main types of retracement :

- Equity reduction: This is a real-time reduction in the balance of the trader's account, including unrealized and realized losses.

- Historical loss: This is a retrospective analysis of the largest loss of account balances during a specific trading period. It provides a historical perspective of the worst-case scenario that traders have experienced.

Relative withdrawal: It measures the amount of withdrawal as the percentage of the highest balance recorded in the trading account, thereby providing a proportional perspective of loss.

- Absolute Withdrawal: This quantifies the withdrawal in monetary terms, indicating a decrease in the real dollar value from the highest account balance to the lowest.

- Floating loss: It reflects the reduction of the account balance when the transaction is still open, considering the unrealized loss or gain.

An Inevitability of the Financial Market

Withdrawal is an inevitable part of the financial market and is more common than you think. It is estimated that the withdrawal rate of the S&P 500 index is about 12.8%, and the withdrawal rate is between 5% and 10%.

In addition, in nearly 200 years of market history, investors have 74% of the time at a loss. Among them, more than 40% of the losses exceeded 20%.

If there are so many falls in the market, it is normal for the assets in your trading account and portfolio to fall. You simply can't escape.

But this is not a bad thing. If you learn how to manage them and adopt appropriate risk management strategies, you can reduce the impact of this situation on your trading performance.

Market Downturns After 2008

In the figure below, you can see another example of the decline in the S&P 500 index, which occurred between June 2008 and March 2012. The decline is as long as three years and nine months, the lowest point is-52%.

For investors, the general rule of thumb is to avoid investment fell by more than 20% -25% of the tool.

It is also important to understand how retracement can help you evaluate your trading strategy and its performance. Remember that the trading strategy with a profit rate of 10 % and a maximum retracement of 2 % is better than the trading strategy with a profit rate of 20 % and a retracement of 20 %.

Institutional investors need to take this into account, because their investments are huge.

However, keep in mind that relying solely on withdrawal is not a feasible strategy. It may vary from tool to tool, and cannot reflect the impact of political news, market news, government policies, etc.on prices. In addition, it does not consider the random changes of stocks or funds.

What is the Withdrawal in the Transaction?

Losses in trading are important because they can help traders measure the historical risk of the instrument or assess its performance.

For example, the withdrawal of ETFs, futures contracts, or stocks can indicate the past risk and volatility of the tool. In this way, traders can better determine whether a particular tool meets their risk tolerance and investment objectives.

In the transaction, we can also describe the withdrawal as a downward fluctuation. The greater the retracement, the greater the volatility of a particular tool ( and may continue to be so ).

When analyzing a fall from the perspective of tool price or account value, it is important to note that the time required to recover from the fall is another key feature.

The faster the price of the tool recovers, the more favorable it is for traders. Understandably, the same is true of trading accounts.

For example, if a particular instrument experiences a significant 10 % decline and returns to its peak in just seconds or minutes, the most likely cause is a lightning crash, and investors do not have to worry too much.

However, in general, market declines can take hours to months.

This is different from a loss

Don't confuse withdrawal with loss. Withdrawal is a temporary peak-valley indicator, and the loss is calculated based on the current price or exit price of the purchase price relative to the tool.

How to Measure the Withdrawal of Foreign Exchange?

1.Determine the maximum balance: Determine the peak or maximum value of the trading account. This is usually the starting balance of the account or the highest point reached.

2.Monitor the current balance: track the account balance over a period of time, taking into account realized and unrealized gains or losses.

3.Calculation withdrawal: Traders can express it as a percentage ( relative withdrawal ) or monetary unit ( absolute withdrawal ).

- Relative withdrawal: The withdrawal is calculated as a percentage of the highest balance. Its representation is : ( maximum balance-minimum balance ) / maximum balance * 100.

Or

-Absolute withdrawal: The withdrawal is calculated by the actual currency reduction from the highest account balance to the lowest point, which is expressed as: the highest account balance-the lowest account balance.

4.Assessment of risk tolerance: Compare the calculated withdrawal with the risk tolerance. Assess whether it is within acceptable risk limits. If the retreat exceeds the acceptable risk limit, the trader should adjust the strategy, reassess risk tolerance, strengthen risk management, or seek professional guidance to protect its capital.

How to Control the Loss of Foreign Exchange Trading?

Implement the withdrawal limit

Setting a loss cap means defining the maximum percentage of losses that the trading account can withstand before the trader takes action.

Use stop loss

Stop loss is a risk management tool that allows traders to pre-determine the closing price level of loss-making transactions.

Set the upper limit of the risk percentage of each transaction

It involves determining the maximum percentage of the trading account balance that a trader is willing to bear in a single transaction.

Set positive risk/rate of return

When traders trade, they should establish a risk/return ratio that determines the ratio of potential gains to potential losses. The common ratio is 2:1, which means that the trader's goal is to earn twice the risk they take. By always using a positive risk/return ratio, traders can ensure that their profitable trades exceed their lossy trades, thereby helping to limit losses.

Consider regular withdrawals

Regularly extracting earnings from accounts helps protect trading earnings and reduce overall risk.

Avoid retaliatory transactions

Emotional reactions to losses can lead to impulsive and irrational trading decisions, often referred to as retaliatory trading.