Draw-down and Maximum Draw-down
In a business in order to make profit one must learn how to manage risks. To make profits in trading you need to learn about the various money management strategies discussed on this best learn FX tutorial website.
When it comes to trading, the risks to be managed are potential losses. Using money management rules will not only protect your Forex account but also make you profitable in the long run.
As traders the number one risk is known as draw-down - this is the amount of money you have lost in your Forex account on a single currency transaction.
If you have $10,000 capital and you make a loss in a single transaction of $500, then your draw-down is $500 divided by $10,000 which is 5% draw-down.
This is the total amount of money you have lost in your Forex account before you start making profitable trades. For example if you have $10,000 capital and make 5 consecutive losing positions with a total of $1,500 loss before making 10 winning positions with a total of $4,000 profit. Then the draw-down is $1,500 divided by $10,000, which is 15 % maximum draw-down.
Draw Down is $442.82 (4.4%)
Maximum Draw Down is $1,499.39 (13.56%)
The example below shows the difference between risking a small percentage of your capital compared to risking a higher percentage. Good investment principles requires you as an investor not to risk more than 2% of your total account equity.
Percent Risk Method
2% and 10% Risk Rule
There is a big difference between risking 2% of your equity compared to risking 10% of your equity on a single transaction.
If you happened to go through a losing streak and lost only 20 trades in a row, you would have gone from starting balance of $50,000 to having only $6,750 left if you risked 10% on each transaction. You would have lost over 87.5% of your equity.
However, if you risked only 2% you would have still had $34,055 which is only a 32% loss of your total equity. This is why its best to use the 2% risk management strategy
The difference between risking 2% and 10% is that if you risked 2% you would still have $34,055 after 20 losing trades.
However, if you risked 10% you would only have $32,805 after only 5 losing trades that is less than what you would have if you risked only 2% of your account and lost all 20 trades.
The point is that you want to setup your rules so that when you do have a loss making period, you will still have enough capital to trade next time.
If you lost 87.5% of your capital you would have to make 640% profit to get back to break even.
As compared to if you lost 32% of your capital you would have to make 47% profit to get back to break even. To compare it with the example 47% is much easier to break even than 640% is.
The chart below shows what percentage you would have to make to get back to break even if you were to lose a certain percentage of your capital.
Concept of Break Even
Account Equity and Break Even
At 50% draw down, one would have to earn 100% on their invested capital - a feat accomplished by less than 5% of all traders worldwide - just to break even on an account with a 50% loss.
At 80% draw-down, one must quadruple their equity just to bring it back to its original equity. This is what is called to "break even" i.e. get back to your original account balance that you deposited.
The more you lose, the harder it is to make it back to your original account size.
Money management is about only risking a small percentage of your capital in each transaction so that you can survive your losing streaks and avoid a large draw-down on your account.
In Forex, traders use stop loss orders which are put in order to minimize losses. Controlling risks it involves putting a stop loss order after placing an order.
Effective Risk Management
Effective risk management requires controlling all the risks. One should come up with a clear money management system and a plan. To be in Forex or any other business you must make decisions involving some risk. All factors should be measured to keep risk to a minimum and use the above tips on this article.
Ask yourself? Some Tips
1. Can the risks to your investing activities be identified, what forms do they take? and are they clearly understood and planned for? All the risks should be taken care of in your Forex plan.
2. Do you grade the risks faced by you when trading in a structured way? Do you have a trading plan? have you read about this topic which is thoroughly covered discussed here on this Site.
3. Do you know the maximum potential risk of each exposure for each transaction that you place?
4. Are decisions made on the basis of reliable and timely information and based on a strategy or not? Have you read about Forex systems here on this website tutorial lessons.
5. Are the risks large in relation to the turnover of your invested capital and what impact could they have on your profits margins and your margin requirements?
6. Over what time periods do the risks of your trading activities exist? Do you hold positions long term or short term? what type of trader are you?
7. Are the exposures a one-off or are they recurring?
8. Do you know enough about the ways in which your Forex risks can be reduced or hedged and what it would cost if you did not include these measures to reduce potential loss, and what impact it would make to any upside of your profit?
9. Have your rules been adequately addressed, to ensure that you make and keep your profits.