What is Drawdown in Forex Trading and the Different Types of Losses

Introduction: The Importance of Understanding Drawdown

Every trader must face the reality of the market: losses are part of the game. Forex trading is not just profits; even the most skilled traders find their account balances decreasing. Often, the key question isn’t whether to avoid drawdowns, which mean losses, but how to document and manage them. In this article, we will explore the meaning of Drawdown, different types, and strategies to keep your account resilient under pressure.

What is Drawdown: Basic Understanding

Drawdown refers to the decline of your account balance from a peak to a trough over a certain period. To simplify, think of drawdown as the “withdrawal” or “decrease” of your capital.

Here’s a basic example: if you start with an account of 10,000 THB and, after consecutive losses, the balance drops to 8,000 THB before recovering to the original level, your drawdown is 2,000 THB. This metric tells the story of the risk you’ve taken.

Why is Drawdown Important?

First, it measures your strategy’s capability. A large drawdown indicates high risk acceptance or potential strategy issues. Second, it helps you set recovery goals. The larger the drawdown, the higher the return needed to recover. For example, if you lose 50%, you need a 100% gain to break even.

Five Types of Drawdown Every Trader Should Know

1. Equity Drawdown: Real-time visible loss

Equity Drawdown measures the decrease in your account equity as displayed in your trading system, including unrealized losses (not yet realized) and realized losses (already closed). It fluctuates minute by minute due to market volatility.

Real example: You start with 10,000 THB, and open trades are temporarily in loss, reducing your balance to 9,000 THB. At that moment, your Equity Drawdown is 1,000 THB. When the market swings back, it might decrease further to 500 THB or increase to 1,500 THB.

Actual meaning: This metric reflects the true psychological stress of trading and helps you monitor risk in real-time.

2. Historical Drawdown: Lessons from the past

Historical Drawdown is the largest loss your account has ever experienced from the first day of trading until today. It provides a snapshot of your worst past scenario.

Example: Your account grew from an initial 10,000 THB to a peak of 15,000 THB, then the market turned sharply, and your account dropped back to 10,000 THB. Therefore, your Historical Drawdown is 5,000 THB (15,000 - 10,000).

Usage: Knowing your past maximum drawdown allows you to set risk management goals to avoid repeating that loss.

3. Relative Drawdown: Focus on percentage

Relative Drawdown shows the loss as a percentage of the maximum equity. It’s a fairer measure because it weights losses relative to account size.

Formula: (Max - Min) ÷ Max × 100

Example: Your account grows from 10,000 THB to 20,000 THB, then drops to 15,000 THB. Relative Drawdown = (20,000 - 15,000) ÷ 20,000 × 100 = 25%

Importance: A 25% Relative Drawdown might sound worse than a 5,000 THB loss (Absolute), but it provides a more accurate picture, indicating you lost a quarter of your peak.

4. Absolute Drawdown: Straightforward counting

Absolute Drawdown is the loss from your initial capital. It answers the question: “How far am I from my original deposit?”

Formula: Initial deposit - lowest account balance

Example: You deposit 10,000 THB, and your account drops to 8,000 THB. Absolute Drawdown = 2,000 THB.

When to use this metric: For beginner traders, Absolute Drawdown clarifies “how much money I lost” in real cash terms.

5. Floating Drawdown: The risk floating in the air

Floating Drawdown is an unrealized loss from open trades. It can be highly volatile because the market is still moving.

Example: You open a BTC position, and the market moves against you, reducing your balance from 10,000 THB to 9,200 THB. Floating Drawdown is 800 THB. However, if the market turns around, it could become 500 THB or even a profit.

Practical significance: Floating Drawdown indicates the real risk of your open positions, helping you decide whether to “scale out” or “close to cut losses.”

Clear Calculation Formulas and Examples

Five Strategies to Control Drawdown

A. Set Clear Drawdown Limits

Many traders set objectives like “I will stop trading when Drawdown reaches 10%” or “15% of the account.” This discipline helps avoid emotional decisions during losses. When reaching the limit, stop trading and reassess your strategy.

B. Use Reasonable Stop Losses

Stop Loss is a pre-set price level to automatically close a trade. For each trade, set a Stop Loss 1-3% away from entry depending on your strategy. This prevents a single loss from destroying your account.

C. Control Position Size

Before opening a trade, decide how much you are willing to risk per trade. A common rule: risk no more than 2% of your account balance. So, if your account is 10,000 THB, each trade should risk no more than 200 THB. This discipline keeps drawdown within manageable limits.

D. Use a Good Risk/Reward Ratio

When entering a trade, aim for a profit target at least twice the risk. Example: risk 100 THB, target 200 THB. This 2:1 ratio helps winning trades compensate for losing ones and reduces overall drawdown.

E. Take Profits Regularly

As your account grows significantly, consider withdrawing some funds. This is not giving up but protecting gains. By removing profits from the trading account, you prevent large drawdowns from wiping out accumulated gains.

F. Avoid Revenge Trading

This is the most critical point. When your account is in massive drawdown, the urge to “get back” is intense. This emotion leads to high-risk decisions, often making things worse. Instead, accept the losses, return to your strategy, and trade with discipline for the next day.

Conclusion: Understanding Drawdown for Sustainable Trading

Drawdown is not the worst thing that can happen to a trader; it’s part of trading. The key is understanding that there are various types of Drawdown, each telling a different story about your performance. Traders must recognize that drawdown means temporary loss, not the end.

By monitoring Equity Drawdown, evaluating Historical Drawdown, understanding Relative Drawdown, calculating Absolute Drawdown, and managing Floating Drawdown, you gain a comprehensive view of risk.

Remember, successful traders are not those who never experience drawdowns but those who evaluate, manage, and learn from them.

To ensure your strategy’s effectiveness, try trading on a demo account first. Many online trading platforms offer demo accounts with virtual funds, allowing you to practice without real risk. Testing your strategy on a demo before live trading is a smart move.