Different Types of Drawdowns in the Prop Trading (2024)

In the rapidly evolving field of prop trading, risk control is critical. Drawdown kinds are important indicators and ideas that are used to evaluate possible losses and safeguard trading money. The term “drawdown” refers to the amount that a trading account’s value decreases during a given period, from its highest to lowest point. Traders, especially those in proprietary trading businesses (prop firms), use it as a formidable tool to assess the efficacy of their tactics and reduce possible losses. In this article, we’ll examine the many forms of drawdown that exist in the prop company sector as well as the essential elements of each.

Various Drawdown Types in the Prop Industry

Let’s examine each form of drawdown separately.

Drawdown Dependent on Balance

To evaluate the risk and possible losses of a trading account, forex traders employ the idea of a balance-based drawdown. It measures the greatest reduction in the account balance from its highest value, typically given as a percentage. Balance-based drawdown gives traders a better understanding of the possible loss they might incur during a given trading session.

Important elements of drawdown depending on balance:

  • Balance

The whole amount of money in a trading account is shown by the balance. This covers the initial deposit as well as any gains or losses from trading. It’s the net amount that may be used for trade.

  • Retraction 

The term “drawdown” describes the account balance’s peak-to-trough decrease over a given time frame. It calculates the percentage decline between the maximum balance attained and the lowest position encountered. Losing trades or a string of losses in a row might cause a drawdown.

  • Drawdown Based on Balance

The assessment of decline as a proportion of the trading account’s greatest balance attained is known as a balance-based drawdown. It helps traders evaluate the possible losses they can experience and gives them a better grasp of the risk involved in their trading techniques.

How to calculate balance-based drawdown

When evaluating the fall or reduction in a trader’s account value over a given period, from its peak point to its lowest point, the balance-based drawdown method in forex trading is employed.

Here’s a simplified summary:

  • Maximum Equilibrium

Find the biggest amount that your trading account ever hits in a certain time frame. Your account balance’s greatest or peak value is represented by this high point.

  • Balance Through

Find the lowest amount that the account balance falls to following its highest value. During the drawdown period, this low point represents the lowest value or the bottom of your account.

  • Figure out the Drawdown

The difference between the highest and lowest balances is calculated as a percentage of the highest balance to calculate the balance-based drawdown. The drawdown, or the amount that the account lost from its peak to its lowest, is represented by this percentage.

Stated in various ways, a balance-based drawdown is a method of determining how much the value of your trading account has dropped over a certain period from its peak to its minimum. For traders, it is a crucial tool for risk management as it allows them to estimate the possible drawbacks or losses that their methods may experience.

Drawdown based on Equity

In the world of forex trading, managing risk and potential losses is crucial to achieving success. One of the key concepts used for this purpose is equity-based drawdown. Unlike balance-based drawdown, which only considers the reduction in the trading account’s balance, equity-based drawdown takes into account the equity of the account, which includes both the balance and the floating profit or loss of open transactions. This means that equity-based drawdown provides a more comprehensive view of the account’s overall performance, as it considers the impact of both profitable and losing trades. By understanding and monitoring equity-based drawdowns, traders can make better-informed decisions and manage their risk more effectively.

The following are some of the key components of balance-based drawdown:

  • The unrealized profit or loss from open positions is included in the calculation of the unrealized portion of the equity, which reflects the current worth of the trading account. It refers to the total amount of money in the account after deducting all of the expenses.
  • As was discussed previously, drawdown is a measurement that determines the peak-to-trough fall in the value of the account within a particular period. It is a representation of the percentage decline that occurred from the maximum level of equity experienced to the point where it was at its lowest.
  • Drawdown is measured as a percentage of the maximum level of equity that was ever obtained in the trading account. This is referred to as an equity-based drawdown. It takes into account not just the balance but also the profit or loss that has been accrued from open trades. Drawdowns based on equity provide traders with a thorough knowledge of the possible losses they might incur in the future by taking into account both realized and unrealized earnings or losses.

The formula for calculating drawdown depends on equity

  • Determine the point in a certain period at which the equity in the trading account reached its maximum value. This value serves as the starting point and reference point for the drawdown measurement.
  • Find the point at which the equity in the account drops to its lowest point following the peak value. This figure reflects the lowest point reached during the downturn.
  • Determine the percentage difference between the highest and lowest levels of equity, and then calculate that difference as a percentage of the highest level of equity. This percentage indicates the drain from the equity in the account.

Drawdown measured in terms of equity is an important indicator for risk management in FX trading. It gives traders a more realistic picture of the success of their accounts by taking into account both realized and unrealized earnings or losses. Traders can make educated decisions regarding position sizing, risk management, and altering their trading methods when they monitor equity-based drawdowns. These decisions allow traders to safeguard their money and maintain sustainable trading performance.

Complete Downsizing

In the world of forex trading, the term “absolute drawdown” refers to the whole amount that a trading account’s value decreases from its highest to the lowest point. Absolute drawdown is reported in the account’s base currency, as opposed to balance-based or equity-based drawdown, which are expressed as percentages.

Essential elements of total drawdown:

  • As previously stated, drawdown is the reduction in a trading account’s value from its peak to its trough. Depending on the kind of drawdown under consideration, it calculates the decline in either the account balance or the equity.
  • The precise monetary amount that the trading account’s value drops from its peak is known as the absolute drawdown. It measures the variation between the account’s peak value and its lowest value over a given time frame.

How to determine the total drawdown

  • Determine the trading account’s maximum value throughout the allotted period. Depending on the situation, this might be the maximum amount of equity or balance.
  • Find the trading account’s lowest position following its high. This is the drawdown’s lowest point.
  • Determine the amount that separates the top and lowest values. The outcome is the total withdrawal, which is stated in the base currency of the account.

Comparative and Trailing Drawdown

In forex trading, the term “relative/trailing drawdown” refers to the notion of calculating the greatest decrease in a trading account’s value from its high, which is updated continually as new peaks are attained. It gives traders a dynamic evaluation of the account’s drawdown that takes into consideration the account’s maximum value at any given moment.

Important elements of the trailing/relative drawdown:

  • The term “drawdown” refers to the reduction in a trading account’s worth from its maximum value to its minimum value. Depending on the situation, it calculates the decline in the account balance or equity.
  • The continuous assessment of drawdown, when new peaks are attained in the trading account, is known as relative/trailing drawdown. It records the biggest decrease from the account’s highest value to its most recent top.

How to determine trailing/relative drawdown

  • Determine the trading account’s maximum value throughout the allotted period. Depending on the situation, this might be the maximum amount of equity or balance.
  • As fresh heights are hit, keep a close eye on the trading account’s current worth.
  • Determine the amount that differs between the maximum value that was attained and the present value. This discrepancy shows the relative/trailing decline.

Given that it takes into account the most recent peaks, relative/trailing drawdown is a useful statistic in forex trading since it gives traders up-to-date information on the account’s decline. It enables traders to evaluate risk and possible losses in light of the most recent market conditions.

The Bottom Line 

When it comes to evaluating risk, prospective losses, and the efficiency of trading techniques, these various kinds of drawdown are necessary for prop trading. Traders can make educated judgments on position sizing, risk management, and adjustments to their trading tactics when they analyze the different types of drawdowns. In the context of dynamic market conditions, it functions as a tool for risk management and protecting trading capital.

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