What is drawdown and how to manage it

Drawdown is the drop in your account from a high point to a later low. It is the number that tells you how much pain a strategy puts you through, and it is also the number prop firms use to decide when to close your account.

How drawdown is measured

Take the highest value your account reached, the peak, and the lowest value it fell to afterwards, the trough. The drawdown is the difference, usually shown as a percentage of the peak. An account that rises to 10,000 and then falls to 8,500 is in a 15% drawdown.

Maximum drawdown is the largest such fall over a period. A strategy with a great total return can still have a maximum drawdown that most people could not stay disciplined through.

Why recovery is harder than the loss

A percentage loss needs a larger percentage gain to recover, because the gain is calculated on a smaller balance:

• A 10% drawdown needs about 11.1% to recover.
• A 20% drawdown needs 25%.
• A 30% drawdown needs about 42.9%.
• A 50% drawdown needs 100%.

This asymmetry is the strongest argument for keeping single-trade risk small. A string of ordinary losses should dent the account, not break it.

Balance versus equity

Balance counts closed trades only. Equity also counts the floating profit or loss on open trades. Broker margin rules and many prop firm drawdown rules are measured on equity, so an open position that is deeply negative counts against you even before you close it. Always check which of the two a rule uses.

How prop firms use drawdown

• Daily loss limit: the most the account may lose in one day. The definition of the day, and whether floating losses count, is set by the firm.
• Maximum drawdown: the overall loss the account may reach. It may be static, measured from the starting balance.
• Trailing drawdown: a limit that rises with your highest point, so your room to lose shrinks as you profit.

Rules differ between firms and change over time, so the only reliable source is the firm's own current rule text.

Ways to control drawdown

1. Fix a small risk per trade and size positions from the stop distance so every loss is the amount you planned.
2. Set a daily stop: a loss at which you stop trading for the day, set well inside any firm limit.
3. Watch correlated positions. Three trades on pairs that move together are close to one bigger trade.
4. Reduce size, not just frequency, during a losing streak, and return to normal size only after a period of following your rules.
5. Avoid the trades that create big single losses: averaging down, removing stops and doubling up after a loss.
6. Track your drawdown from your journal so it is a measured number, not a feeling.

Drawdown in a losing streak

Even a strategy with a positive edge produces losing streaks, and the length of a streak depends on the win rate. A strategy that wins half its trades will, over a few hundred trades, very likely have a run of six or more losses in a row at some point. If each loss costs 2% of the account, six in a row is roughly an 11.4% drawdown, because each loss is taken from a smaller balance.

• At 1% risk per trade, six losses in a row cost about 5.9%.
• At 2% risk, about 11.4%.
• At 5% risk, about 26.5%.
• At 10% risk, about 46.9%.

These figures show why a risk per trade that feels acceptable on one trade can be unacceptable across a streak. Decide your risk per trade by asking what a bad run would do to the account, not what one loss would do.

Drawdown and prop firm limits

A daily loss limit that is small compared with your normal trading range is easy to hit by accident. If your risk per trade is 1% and a firm's daily limit is 5%, five losing trades in a day breach it, and slippage or a wide spread can make it fewer. Work backwards from the limit to a risk per trade and a daily stop that leave a comfortable margin.

What to do when you are in a drawdown

1. Check whether you are following your plan. A drawdown from correct execution is different from one caused by rule breaks.
2. Reduce size until you have a run of trades that follow the rules.
3. Review the losses in your journal for a pattern such as time of day, pair or setup.
4. Do not try to recover it in one trade. Recovery is a matter of returning to normal size and normal process.
5. Consider a pause if you are trading emotionally.

A drawdown is information as much as damage. What matters is whether it came from the strategy behaving as its statistics suggested, or from you departing from the strategy.

Put a number on it

Decide before you start what drawdown would make you stop and re-examine your approach, and write it down. Having that line in advance is what stops a bad week becoming a blown account.

Key takeaways

• Drawdown is the fall from a peak to a later low.
• Recovery needs a bigger percentage gain than the loss.
• Choose risk per trade by asking what a losing streak would do, not one loss.
• Check whether a rule uses balance or equity, and how it resets.
• Reduce size in a drawdown and review the cause before you try to recover.