Drawdown in forex refers to the difference between the highest point in the trading balance in your account and the next low point in the trading account balance. The difference in the account balance is the capital lost or drawdown.
There are many nuances that investors must incorporate in their daily monitoring. When it comes to Forex, paying attention to drawdowns is vital. With that same mindset, making an action plan for future trades and investments that aren’t overly intense is essential to long-term growth with minimal loss.
Why Is Drawdown Important?
When you find that your trade has experienced a significant drawdown, you know that you need to adjust something to avoid having it happen again. At times, Forex drawdown will only be a small amount, but other times it can be more significant and require a considerable change in strategy.
Many equate drawdown to the level of survivability that their investments will have in the long run. Each drawdown that occurs sets the stakes higher for future trades to make up the difference and keep the investment on track.
Different Types of Drawdowns
When it comes to drawdown, there are a few varieties:
When you experience relative drawdown, you typically only realize it when you reach the point of closing your position. Most relative drawdowns are temporary and can quickly correct themselves.
A maximum drawdown is what we describe in the standard definition of drawdown. This term applies to the difference between your highest and lowest account levels when investing in Forex.
When looking at your absolute drawdown level, you are referencing your loss in how it compares to your initial deposit. Those with a significant initial investment will often be interested in how the loss corresponds to the overall amount.
How To Calculate Drawdown
As an investor, you want to know the details of your finances. Another element you want to be aware of is how it has disrupted your overall investment goals. There is a specific way to calculate the Forex drawdown that can help you better understand the breakdown of all the various elements.
- Take your highest account level.
- Subtract the lowest account level from the highest
- Divide that number by the highest account level
- Multiply the answer by 100 and get the drawdown in percentage
For example, if you initially deposited $10,000 and your account got down to $2,000, you would first subtract the two numbers. With $8,000 as your answer, you would divide by the highest number.
The dividend in that scenario would come out to be .8. From there, you would multiply by 100. Your final result ends up being 80%.
How To Avoid Drawdown
Experiencing a drawdown can be frustrating and stressful. As it is inevitable to have a drawdown occasionally throughout your investment journey, you can put things in place to minimize the frequency. There are several things you can put into place to avoid drawdowns in your investment, including the following:
Set a Stop Market Order
A Stop Market Order allows you to make a predetermined boundary to protect your investment. When you put in a Stop Market Order, you tell the system that if a currency reaches a specific rate, you want to buy or sell your position.
Having this order in place helps you from losing all of your investment if the market for that specific currency goes down.
Use a Loss Limit
To avoid a massive downslide in their investments, some people use a route similar to a Stop Market Order, called a Loss Limit. This method allows them to set a capacity for each day they don’t want to surpass. As the day goes on, trades will stop once the account reaches its limit.
For those who consecutively reach their loss limit multiple days in a row, it can be a sign to change their investment strategy.
To obtain the highest level of buying power and the hopeful return it will provide, people will often turn to brokers to use leverage. With leverage, you can increase the buying power with small capital.
The downfall of leverage is that while it is possible to gain a considerable amount in return, it’s likewise entirely possible to lose a significant amount of earnings.
Avoid Emotional Trading
In a move that individuals will typically enact out of desperation, investors will take drastic measures to try to recoup any losses they are experiencing. Throughout this, they may think they are correcting their route, but they are putting themselves in harm's way.
The best way to correct a steep drawdown is slowly and steadily. You don’t want to overcorrect the ship and have it come tumbling down on the other end.
Beware of Volatile Markets
Like the stock market, Forex is a volatile market. Therefore, you want to be mindful of all issues currently taking place within the market itself. If the market is doing poorly, you will want to make conscious moves that will still work for your investments.
Some people refrain from any considerable changes to their investments when the market is challenging. Some management still needs to happen, but limiting transactions where you can is best.
Why Do People Trade Currencies?
Forex trading as an investment can be risky. It is possible to make money based on the price action of currency rates. In what is a common thread, those who perform business in other countries take advantage of low currency exchange rates where they can lock in prices for a lesser amount.
At its core, a Foreign Exchange takes place each time a traveler visits another country and converts their money into the local currency. You may not realize it at the time, but you are participating in Forex.
It’s worth noting that those who utilize Forex as an investment strategy take it a step further than what a simple currency exchange does. Some individuals, who refer to themselves as currency traders, will actively purchase various currencies during times of lower exchange to make money when they sell or trade it back.
How Popular Is Forex Trading?
Many are surprised that Forex trading is the most popular trading strategy available on the market. There is an average of 5.1 trillion dollars done in turnover daily. The market is open to traders 24 hours a day, five days per week.
When Forex trading, you will notice that some countries are often traded in pairs. Typically you will see the following partnered together:
- USA (USD) and Switzerland (CHF)
- Europe (EUR) and Canada (CAD)
- Great Britain (GBP) and New Zealand (NZD)
There are many different pairs variations involved in Forex trading, mostly done where the advantage is most enticing to the one making the trade. Other popular pairs include USD and EUR, USD and GBP, and USD and CAD.
Forex trading is the most popular investment strategy worldwide. Trillions of dollars will move throughout the exchange on a daily basis. Many want to involve themselves in this investment opportunity outside of standard currency conversion, but it’s not something you can jump into without a plan.
Foreign Exchange requires investors to frequently monitor the market, pairing up various currencies and striking when the rates are optimal. There will be many occasions when you suffer a significant loss, and you need to do everything in your power to correct the issue slowly and not with emotion.
Overall, Forex is an investment strategy that many participate in every day. A drawdown in Forex is inevitable, and it isn’t something an investor can bypass. With this being said, there are sound strategies that you can implement to reduce the damage that a drawdown can cause and make recovery smoother.