How to Keep Drawdown in Forex Under Control

Man with umbrella holding up orange arrow

Happy Friday!

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%.

Chart showing trading balance drawdown

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

chalkboard with favorable risk to reward ratioWhat 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

Man drawing lower risk conceptThe 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

Man with hands tiedAside 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

Man walking away from computerAs 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.

Final Words

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:

  1. Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
  2. Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.
  • ANJAN DAS says:

    Thanks a lot for sharing lots of insight…
    I’ve a question that, if I want to analyse & trade only one market, whether it be stock, commodity or forex, will it be right approach focusing on only one market? off course I consider this with some comfortable trade set up & proper money management system with strong discipline.

  • Ronnie RT Maronza says:

    Tnx Justin i jst wrote down all notes so i kip chcking dem as alwys as possible if i start loosing it.👍👍

  • Shaun says:

    Hi there, when trading the 4 hour chart, what is the best lower timeframe to look at to enter a trade.

    Thanks

  • Caleb says:

    Am back from a break

  • Okpala says:

    Justin, first of all i will thank you for your countless assistance for young traders and me. you really make me understand that what made me a trader is not to have a deposit in my trading platform but to have sense of managing my risk bcus is what keeps me on in trading. Good work my friend!

  • Nse Sam says:

    i make tangible money consistently in my demo account does that imply that i will make good money in my live account?

    • Enoch joseph says:

      Making money in a demo account does not guarantee that when you put money on a live account your going to profit consistently, 90% of forex trading is about emotions, demo account is not your money at stick, you can leave the trade open for about a month without any emotion involved, but when it come to live account my brother it another story completely

      • Roy says:

        Very true Enoch. Demo is good for strategies and knowing how to trade consistently.

        Live trading is all about emotions the psychological part of trading.

        Many traders do well on demo only to crumble on live accounts.

        It helps to read books about trading psychology and money management.

        Trading live will take years to be good at because real money hard earned money is on the line.

        Learning price action and having a trading plan can help with discipline and patience to only take the best set ups!

  • Howard Hill says:

    excellent article Justin, you covered all points well, thank you!

  • KnightHawk says:

    Great Piece, thanks for your insight. Want what the markets wants!!!! cheers!

  • Michael says:

    Often times while reviewing other trader’s ideas and setups I notice that the chart they post is not identical to mine. Specifically; they may post a 4 hour EURUSD chart, and the candles do NOT match my candles even though we are both using the same chart package, currency pair, time frame etc… What is going on? How can MOST of the candles be identical, but several have different opens, closes, or even ranges?

  • Abner says:

    So frustrated don’t even what to do or what to ask .
    Have a small account of $1000 and already down 50%
    How can you help? Thanks!

    • Enoch joseph says:

      The mindset people approach the market with is the leading cause of there failure,most of the new people who dive into forex realise that forex is not easy as it sounds so brother the best advice I can give you is leave the live account for now. Get educational aspect of it when you are done try you strategy on a demo account when it works you can come back to your live trade

  • A Nonymouse says:

    Seems to me that risk is inversely related to timescale of trading. So while 2% of trade might be appropriate for 1 or 5 minute minute time frame, trading on the daily weekly or monthly time frame might require something like 10% of bank as the risk. It might be better on a longer time frame to divide the bank into three parts, and trade one part compounded until it halves or doubles.. If one trades on trend on a daily timeframe, using all major indicators and their combinations one might get three good trades in a week, or perhaps less, but the risk of a losing daily timeframe trade with longer timeframes confirming trend and using heiken ashi candles with exit on one reversing colour candle can be less than 50% and will decrease with skill and use of confirming indicators such as volume weighted moving averages, or for the more cautious the parabolic indicator family

  • Jaime Singson says:

    Hi justin:

    can you also talk about how to evaluate if a market is overextended?

  • Hiru says:

    Dear Sir,
    how can i find out resistant & support label. please help me sir.

    your faithfully
    hiru

  • Sarma says:

    1) Select a pair that is not very volatile. I choose AUD/CAD.
    2) Day trader must be able to calculate the relative strengths of numerator and denominator and must be able to predict if the pair will look up or down today.
    3) Control lot size. For AUD/CAD, I choose USD 2,600 of Equity per lot while buying and USD 2,000 per lot while selling.
    4) It will be nice to be able to predict the high & low for the pair. Also the high zone and the low zone.
    5) If you have made sufficient profit close down for the day.
    6) One trade a day. Set it and forget it.

  • Ibinabo Cotterell says:

    Thanks a lot. You are a great teacher.

  • ANANT says:

    IS THE MOVEMENT IN FOREX MARKET PURELY ON DEMAND SUPPLY BASIS OR THERE IS A SCOPE FOR MANUPLATION

  • Solomon says:

    Thanks and God bless.

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