If you are into Forex trading, you are sure to experience a losing streak periodically. It is your ability to deal with such phases that decides whether you have what it takes to be a consistently profitable Forex trader.
What is a drawdown?
In Forex trading, the difference between the highest balance and the next lowest balance of your trade is known as drawdown. The difference between the high and the low (trough and peak) shows the lost capital due to the loss in trades. Hence, if your $50,000 in your trading account dips to say $45,000; then your account has encountered a drawdown of 10%. The time taken for your account to recover is also an important factor.
Forex Losses: The inevitability of drawdown
Forex trading comes with the inevitability of facing drawdown. It is a phenomenon that all speculators have to face. Drawdown is used by Forex enthusiasts to measure the quantum of loss in capital incurred from your trades. This information allows you as a trader to kind of foresee if your trading system is equipped to survive over the short or long time period. It provides you a fair judgment on the viability of your trading setups. Traders use these drawdown metrics to try and circumvent a loss before that loss eats into their profits.
Ironically, without drawdown, it will be impossible for you to –
- calculate the risk factor for future investments
- analyze your investments
- keep a check on your investments
Dealing with drawdown
Investors employ various means to deal with a drawdown to reduce the negative effects. The following time-tested methods are used by investors more often:
Diversify: Keeping your eggs in different baskets is one of the best methods. Invest in equity funds, mutual funds, real estate, gold, commodities, and bonds. We all know that market does not affect all instruments of investment in a similar way. Thus, having a wide range of portfolio verticals is always advisable.
Minimize loss: Draw a benchmark that determines till which point you would be willing to absorb the loss. If you think you will be able to withstand a loss of up to 2%, then it is advisable to stop trading once you touch that threshold. Wait till the situation improves. This will help you to avoid losses at a later stage. You must also know how long you can wait for the situation to improve.
Know when to quit: If the market is experiencing a continuous drawdown and not showing signs of improvement then you should know at which point you should quit and walk away without suffering a huge loss beyond your set exit price target. If you notice that your account value is southward-bound, immediately do whatever possible to reduce risk.
Historical data: Go through the historical data of the market before investing to get a feel of the trend. This will not only give you an idea of assets to invest in but will also alert you with clues when a drawdown is just around.
Learn from mistakes: Not to repeat the same mistakes committed earlier and rethinking your strategy and tweaking your trading plan is not a bad idea at all. Overlooking a mistake due to overconfidence could lead to disastrous effects. Playing within the pre-drawn risk boundaries is more advisable.
Spot the signs early!
Unless there are major global triggers like the 2008 recession crisis, an act of war, or global financial scams that wreak havoc across all financial indices, it is practically not possible to insulate yourself from a drawdown. It is a fundamental part of Forex trading. History repeats itself, so always use history as reference points and look for clues. But what you can also do as a smart trader is minimize your losses whenever you encounter a negative phase. The drawdown offers you an insight and warns you of how deep the loss is running into. You individually have to pick and choose your battles as a Forex trader. You surely can have trading plans with specific exit points and risk appetite predefined, but price action is something that you can never control. But you can of course choose to want to act or not to act in such situations. Traders seem to try harder during drawdown situations in order to recover back what they lost. Remember, that the market will always win no matter how hard you try to resist. So, if your losses are continually mounting even after you have done everything possible to arrest it, it is advisable to always take a hiatus. Spend time with family. Come back later and work back on your charts. You will see how things will feel different and you will be able to better restart at an opportune time.
Loss is part and parcel of a trading business. One should not expect your investment to always experience a high. Like any other business, investors should understand that they are going to suffer a loss at some point in time. The expertise with which an investor use measures to minimize a loss will make all the difference. If you experience a long spell of high in your trading business, it does not mean that you are not going to suffer any loss in the future. You are not invincible. As an investor, you should start preparing to buffer any loss you may suffer during that drawdown spell. Use your drawdown scores to good effect. You may book lesser profits in doing so, but it will make you a disciplined trader who works with a proper trading plan. As an investor, you should not compromise strategy with emotions. Involving emotion in trading is a recipe for disaster. The flipside of the drawdown is that it does not occur in succession and you can still enjoy a lucrative business. It is imperative that you have in place a fool-proof plan to deal with a drawdown to not only minimize the negative effects but use it as an advantageous tool.