This week’s question comes from Jonathan, who asks:
What’s the best way to keep drawdown low when trading Forex?
If you trade Forex long enough, you will experience a losing streak.
How you cope with it will determine whether or not you have what it takes to become consistently profitable.
The best traders know how to ensure they land softly, while those who struggle tend to crash and burn.
But you know what?
It’s actually much simpler to avoid the crash and burn scenario than you might think.
The best traders know that losing streaks become magnified when emotions get involved. In order to minimize the damage from a loss, they simply reduce their emotional involvement.
In other words, they don’t feed their emotions.
If you want to learn about losing streaks and drawdowns, including how the best traders handle them, you’re in the right place. I’m even going to share a simple 4-step process to control drawdowns that you can begin using right away.
Read on to learn how you can manage drawdowns like a pro.
What Is Drawdown?
Simply put, drawdown is the reduction of one’s trading capital measured from peak to trough.
So if you grow your account to $100,000 and lose $20,000, the drawdown is 20%.
One thing that often confuses traders is that these losses do not have to be consecutive. In other words, you can have profitable trades and still experience drawdown.
Once your account grows beyond $100,000, a new peak begins and thus resets any subsequent drawdown period.
The 4-Step Process to Control Drawdowns
It’s imperative that you have a defined process in place to control drawdowns. Think of this as the disaster prevention plan for your trading business.
Here’s an outline of how I manage subpar performance when trading Forex.
1. Keep risk as low as possible
What would happen if you lost 20 trades in a row?
Think about that for a moment. Take the percentage you have been risking per trade and multiply it by 20 and see what you get.
If it’s above 100, you have a serious problem.
At some point in your Forex trading career, you’re going to experience a drawdown period. And if you trade long enough, you will experience at least one that is quite severe.
Now, I’m not saying that you will lose 20 trades in a row at some point. Nobody knows what will happen tomorrow, much less several months from now.
However, if you aren’t in a position to lose 20 trades in a row and still have remaining capital, you should reconsider your strategy.
So how much of your account balance should you risk per trade?
There’s no universal answer here. It comes down to your tolerance for risk, which only you can determine.
But less than 1% of your balance is a good rule of thumb.
You have probably seen others write about risking 2% or even 3% of your account balance per trade.
If either of those work for you, I say go for it.
As for me, even 2% is too much these days. But again, it depends on your tolerance for risk.
Figure out what 2% of your account balance represents and ask yourself if you are prepared to lose every penny on the next trade—provided it’s a quality setup, of course.
If so, the 2% rule may work for you. Just know that your drawdown will be more severe compared to risking just 1% (or less) of your speculative capital.
2. Reduce risk if losses continue
The second step in this process is to lower your risk per trade if losses continue.
When you find yourself in a trading slump, you have three choices.
The first is to continue risking the same amount per trade. While this option isn’t the worst of the three, it also isn’t going to help you turn things around.
Option number two is the worst offender. Ironically, it’s also what most Forex traders do in drawdown situations. Instead of maintaining the same level of risk as losses pile up, they try to make back what was lost by increasing their risk.
In the trading world we call this ‘revenge trading’. These traders increase their risk from 2% to 4% (or even higher) in a desperate attempt to recover lost funds.
If you have been doing this, it’s only a matter of time before you blow your account.
The third—and best—option is to reduce your risk per trade with each subsequent loss. This guarantees you a soft landing during a drawdown period, rather than a crash and burn experience.
Once you regain your confidence, you can start increasing the risk per trade back to its original level. This usually occurs after two to four winning trades.
3. Set a drawdown cap
Aside from walking away, which we’ll cover next, this is arguably the most difficult step to follow.
Some months it will feel like the entire market is against you. If you haven’t experienced this already, it’s only a matter of time.
One way to prevent losses from piling up when you’re off your game is to set a weekly or monthly cap. Just like you set your risk per trade, you can establish a drawdown cap.
Here’s an example:
Let’s assume you risk 1% of your account balance on each trade. Using this figure, you could set a cap to stop trading if you’ve reached a 5% drawdown for the month.
That means if you lose 5% or more of account equity, you have to stop trading until the next month begins.
Unless you’ve heard of something similar before, that may sound pretty harsh. I mean, what if you hit that within the second week of the month?
You got it—you stop trading until the new month begins.
Of course, you can always modify a rule like this to better fit your style. Instead of waiting until the next month to begin, you could make it the next week.
Either way, this type of rule is incredibly powerful. Not only does it help you avoid the crash and burn scenario, but it also forces you to be more selective about the setups you pursue.
4. If all else fails, walk away
As Forex traders, we have to pick and choose our battles.
Day in and day out we’re at the mercy of the markets. Sure, we can choose the setups we take, including exit points and the amount we risk, but the price action is out of our hands.
But there is one thing we can control every single time…
Whether or not we act.
If things aren’t going your way, you can simply take a break from trading. That’s an incredibly powerful position to be in, yet so few traders take advantage of it.
When faced with a drawdown situation, most traders feel the need to try harder. They want to make back what they just lost as fast as possible.
But the Forex market has a way of pushing back. The harder you try, the more the market resists. And at more than $5 trillion per day in volume, the market always wins.
If losses continue to mount even after reducing your risk and perhaps even your trading frequency, just walk away. Spend time with your family or play your favorite sport. Whatever you choose, just make sure to stay away from your charts.
After a few days or even a full week off, come back to your charts. You’ll be amazed at how a brief hiatus from trading can help you bounce back from a losing streak.
Taking losses is part of trading. It’s a necessary business expense that must be endured in order to find profitable trade ideas.
Just like any business, expenses need to be controlled. But unlike most, the expenses associated with Forex trading are not on a set schedule.
Some months will be great, others mediocre. Then you have months where everything you do goes wrong. It’s time like this when controlling drawdowns is absolutely critical to your success.
Without a defined process in place for how you will handle drawdowns, your emotions are free to run wild. Instead of lowering risk after a loss or two, you’ll be tempted to make back what was lost by increasing leverage.
Don’t make that mistake. It’s far better to lower risk in drawdown periods, and even walk away if you have to, in order to maintain discipline and keep emotions at bay.
By doing this, you satisfy the number one rule of being a trader, which is to protect your capital at all times.
Your Turn: Ask Justin Anything
I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.
To do that, I need your help.
Here’s what you can do to get involved and have your question answered in next week’s post:
- Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
- Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.