Drawdown Forex Trading and Stop Loss are the two parameters that should always be kept in mind when trading Forex because these factors clearly indicate the risk associated with your open trades. Let’s first understand one by one that what these concepts are.
What Is Drawdown Forex Meaning
Losing and earning are the two sides of same coin that means if one comes up the other goes down and when the other comes up the previous one goes down. In simple words, if a trader is losing in one trade then he cannot earn in that trade and if he is earning in one trade then he cannot lose in that trade. So the difference between the percent lost and the percent needed to gain to bring the investment amount back to the original position is the Drawdown. For example, if your investment amount was $10,000 and you lost $5,000 so now you need gain of $5,000 to bring your investment back to $10,000. Now look at these figures in percentage. Your investment was $10,000 and you lost $5,000 so the percent lost that suffered was 50%. Now the question is how much gain you need to bring your remaining investment back to original. If your answer is 50% then it is wrong because 50% of $5,000 is only $2,500 and that would amount to only $7,500 and you are still behind $2,500 from your initial investment. So the right answer is 100%. 100% of $5,000 is $5,000 that would bring your remaining investment back to the original position. This shows that if you have lost 50% of your investment in this case then you need 100% gain to restore the financial position of your account to the original position. The difference between the 100% gain and 50% loss is 50% so your Drawdown is 50%. This is the concept of Drawdown.
Maximum Drawdown Forex Trading
Maximum Drawdown is the biggest drop of price from peak to bottom in a fixed period of time. Maximum Drawdown is equal to or smaller than the difference of maximum loss and the maximum profit. Maximum Drawdown is used at times when enough observations are not present to calculate volatility. This figure depends on the selected time interval. An example of a Maximum Drawdown can be seen in the figure below.
In the figure above, the difference between the green and red line is the maximum drawdown.
Use of Forex Stop Loss
Stop Loss should be set in every trade you place because in Forex Trading if you have used high leverage in a trade without Stop Loss then a single trade without Stop Loss can eat whole of your initial investment. Without a properly determined Stop Loss you will only see losses. Stop Loss should be used because it is a way to limit your loss if the price of your position starts moving in an unfavorable direction. If the price touches becomes equal to or lower than your Stop Loss then the order will be executed and you will have your money recovered from a losing trade by loosing only a part of it. Setting a Stop Loss is a task that should be performed carefully. You can determine and set stop loss in four ways.
How to determine Stop Loss
The first way is placing Equity Stop Loss. In this method, you can decide an amount that you can afford to loose in one single trade and set Stop Loss accordingly. Placing Stop Loss at 2% of your total investment is a good decision. Chart Stop and Volatility Stop are other methods of determining Stop Loss. These methods involve Fundamental and Technical analysis to determine Stop Loss. The difference between both methods is only that Volatility Stop is more accurate as compared Chart Stop because Volatility Stop also considers the volatility of the market. The last method is Margin Stop according to which it is better to divide your total investment into smaller parts and do trading in parts. Bring the next part only if the previous part is lost.