A Forex drawdown is a measuring tool commonly used by all types of investors, including forex traders, in order to determine the potential risk involved in an investment. Forex traders typically use the drawdown function to monitor the performance of their trading strategies.
The drawdown is usually shown as a percentage (%) and is plotted over time to show change over time. It represents a loss or potential loss in the value of an investment, usually after a series of losing trades. Due to its direct link to performance and risk management, many forex traders use drawdown as a tool to identify weaknesses in their trading strategy.
Below is a statistical formula for calculating the drawdown amount or % of a specific investment or portfolio.
D(T) = Drawdown Time
t = Peak
T = Trough
X = Variables
For a simple explanation of how drawdown is calculated, let's say, for example, you have a $10000 trading portfolio. The equity in your account drops to $8000 after a bad trade or a losing streak.
Answer: You lose $2000. The account decreased from $10000 to $8000 reflecting a 20% decrease.
10000 (Peak) – 8000 (Through) = (2000 ÷ 10000) × 100 = 20%
Types of Forex Drawdown
Drawdowns used in forex trading can be divided into three types. These terms are crucial for checking the performance of a portfolio before investing or trading. Furthermore, we can use these different types of drawdowns to determine the potential losses of capital that we might face if we were to use this trading system.
A relative drawdown reflects unrealized losses. As long as you hold onto your position, drawdowns are temporary and only become apparent once your stop-loss is triggered or when you close your position.
Relative drawdown is the difference between the maximum equity high to maximum equity low, it is not fixed as it is measured on the equity.
Relative Drawdown = Maximum value of equity – Minimum value of equity
Relative Drawdown in % = (Max equity value – Min equity value) / (max equity value) ×100
Absolute drawdown represents the difference between the initial deposit and the smallest equity value, showing how much the equity has fallen below the deposit level. The absolute drawdown only occurs when the account value drops below the initial deposit.
Absolute Drawdown formula = Initial Deposit– smallest equity value
Absolute Drawdown in % = (Initial Deposit – smallest equity value) / (Initial Deposit) ×100
Absolute Drawdown helps to evaluate the results of a trading account.
Maximum drawdown is the difference between an all-time high to the all-time low of an account balance.
Max Drawdown Formula = All-time high balance – All-time low balance
Max DD in %= (All-time high balance – All-time low balance) / (All-time high balance) ×100
Maximum drawdown indicates potential downside risk over a given period.
You can learn more about forex drawdown and forex trading strategy and tips at this forex trading forum.