Those individuals who are new to forex trading might find certain terminologies to be unfamiliar to them. One such term happens to be “drawdown” which usually refers to the high-to-low decline that has been experienced by a fund or trader over a particular span of time.
Why Is Drawdown So Important ?
According to many individuals, historic drawdown aids in figuring out any risk involved with an investment. Traders or funds that have experienced years of significant drawdown are deemed to be considerably riskier. It is highly probable that traders or funds are going to experience periods of modest performance, and even a system which happens to be lucrative most of the time could possibly go through a prolonged losing streak. It has been suggested by restricted historic drawdown that a Forex trader has been managing risk effectively while risking only a small portion of the total equity every time they open a position. In terms of Forex, a signal trader’s historic drawdown is going to be quoted by all social trading networks for aiding the users to figure out the riskiness of a trader or a signal provider.
Drawdown can be categorized into absolute drawdown as well as maximal drawdown.
By the term “absolute drawdown” we refer to the difference between the minimum point below the deposit level and the initial deposit at the time of the testing period. You will be informed about how significant your loss has become in comparison to the initial deposit. Your deposit will not be at risk in case this value happened to be zero during the test.
On the other hand, “maximal drawdown” implies the optimal difference between the local optimum extremum and the subsequent local minimal extremum in the equity chart. It informs you regarding how low your approach can go after obtaining some profit. In general, it is not advisable to trade with professional advisors having optimal drawdown higher than profit. However, I won’t recommend trading even with expert advisors or strategies having optimum drawdown at levels more than 25% of the total profit. Take into account your individual risk-to-reward ratio and refrain from trading with EAs which don’t comply with it.
For example, in case a Forex trader puts $5,000 for trading with and has lost $2,500 afterward, this is going to be 50% drawdown.
The Limitations of Drawdown While Evaluating Risk:
Despite the fact that drawdown can be beneficial when it comes to figuring out risk it does have certain limitations. Firstly, historic drawdown will not provide any indication of risk for the upcoming days and is actually a measure of the performance in the past. Although a Forex trader might have a relatively low historic drawdown, one cannot assure that they will not blow the entire account the subsequent day. The use of drawdown is limited while trying to assess the risk of a new trader or fund since there might not be adequate data for providing a clear picture of the risk involved with an investment proposition.
Drawdown will prove to be useful when it comes to helping an individual to figure out the risk involved with a specific investment proposition. Although it is important to realize this as a historic measure, one cannot assure that past performance is going to continue into the upcoming days. In spite of this, focusing on drawdown will allow you to understand the type of risks taken by a fund or a trader in the past.
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