Drawdown in Prop Trading

Key Highlights

A drawdown in prop trading refers to the maximum permitted decline in an account’s value from its highest recorded performance. Its role is to assist in preventing excessive losses. 

Examples of drawdowns you’ll encounter as a prop trader include:

• Trailing drawdown
• Daily drawdown
• Maximum drawdown
• Balance-based vs equity-based drawdown

What is Drawdown in Prop Trading ?

Are you a skilled trader looking to update your knowledge of key trading concepts? Or are you just about to make your entry into the world of prop trading and thus interested in researching all its vital concepts?

Regardless of what has brought you to this page, one thing remains: learning what drawdowns are and the different types of drawdowns in use by prop firms will be a great starting point. 

So, what is drawdown in trading prop firms, and why should you care about it? 

Drawdowns are an important aspect of everyday trading and are virtually impossible to overlook or ignore. They form part of the risk in prop trading investments. You’ll come to find that there are trades that will pay off, while others will end in losses. 

The good news is that traders can use trailing drawdowns to adjust their performance, deploy a better trading plan, and understand the risks that come with investing in Futures and commodities. 

Join us below as we take a closer look at what is a daily drawdown in trading and why it matters!

Why Drawdown Matters to Prop Traders ?

In FX, prop, and other forms of trading, an intraday trailing drawdown refers to a decline in the value of your trading account during the trading day. This will, in most cases, involve various trades that will have left the account having a lower value than it had when starting.

Dive deeper into this topic Fixed vs Trailing Drawdown

You must, therefore, understand that an EOD trailing drawdown represents more than a percentage or a number. This drawdown has a direct impact on your psychology, trading performance, and funding status. In a nutshell, an end-of-day trailing drawdown matters for the following reasons:

• It ensures that you abide by the rule management principles advanced by the prop firm to ensure consistency and long-term profitability. 
• A trailing max drawdown limit helps you evaluate the efficiency of your current trading strategy, especially when faced with consecutive losses. 
• The max drawdown in trading serves as a benchmark for the prop companies' risk tolerance. 

Check Our Guide About Understanding Prop Trading Challenges & Rules

Types of Drawdowns in Prop Trading

Throughout my trading journey, I have only encountered six types of drawdowns. And while they may differ in how each works, you should note that their definition and purpose remain the same: they measure the maximum allowed account decline and are there to help the company preserve its capital. 

I’d, therefore, like to stress that prop firms will use these drawdowns to evaluate your performance, measure risk, and determine whether you should get a funded account (Read about How Traders Get Funded?). For this reason, there’s an urgent need for you to understand these six types and how each works. 

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It’s only by understanding this that you can better manage risk  and respect the limits attached to each.

• Equity Drawdown: Before you can learn how to reduce drawdown in trading, you need to first understand what each represents. An equity drawdown, for starters, tracks the decline in account equity. This will include tracking both the realized and unrealized losses. An equity drawdown limit combines both open and closed positions and then uses the resulting information to provide a clearer picture of the health of your trading account. This kind of drawdown is vital to determining the account’s risk exposure when opening new positions.
• Absolute Drawdown: This is a measure of the difference that exists between the account’s starting balance and its lowest equity point during a certain timeframe. An absolute drawdown differs from other types of drawdowns in that its sole focus is on the initial capital losses. 
• Floating Drawdown: It refers to the unrealized losses on all your open trade positions. The floating drawdown represents the decline in equity while the account still has open trades. As a result, this is a kind of drawdown that will fluctuate as the conditions in the market continue to change. Some prop firms have included floating drawdowns in their risk management rules to prevent traders from taking on too many trade sizes at a go. 
• Relative Drawdown: Prop firms use it to measure the percentage decline from an account’s highest equity point over a trading session. It includes the fluctuations happening in the account as it grows or declines. 
• Maximum Drawdown: It’s the total loss allowed by a prop firm from the opening balance throughout the account’s lifespan.
• Daily Drawdown: A daily drawdown refers to the maximum loss permitted in a single trading day. Once you have hit the daily limit, the account will get locked automatically, and you must wait for it to reset at midnight. 

Read our complete guide on this topic Daily vs Max Drawdown

Understanding these six types of drawdowns is a fundamental starting point for every prop trader, particularly those keen on becoming funded. They’re vital to grasping the risk management plan and in understanding the rules used by prop firms to preserve their capital. 

Understand this better here Common Rule Violations

A trader who knows how to perform a static vs trailing drawdown comparison will be able to protect the capital allocated to them and improve their profitability.

Key Definitions in Drawdowns Calculations

Prior to undertaking a daily vs intraday drawdown prop trading firm’s comparison, it will be important to understand the following two elements that are typically relied upon when calculating drawdowns:

• The Drawdown High Point: It refers to the high point from where the prop firm calculates the drawdown. For example, a high point can be the initial account balance or the start-of-the-day balance. Please be advised that this can change depending on the kind of drawdown you’re dealing with. 
• Stop Out Level: It’s the lowest equity or balance. An account that has reached this point is one that’s in violation of the drawdown in question. In this regard, the Stop Out Level will vary depending on the factors used to calculate the drawdown. Keep in mind that this is the point of no return, which will lead to account closure once hit. 

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Summary 

Managing drawdowns is key to succeeding in prop trading evaluations and becoming a funded trader. Below are a few tips on how you can approach it:

• Give yourself a break after incurring consecutive losses: Taking a momentary break from trading will help you assess your trading strategy and identify the areas that may need improving.
• Apply Strict Risk Control Measures: Try to limit your daily risk to around 5% of your account balance. And when trading, do everything possible to spread it out, making sure to routinely adjust positions. It will also be important to learn how to use stop-loss orders. 
• Monitor critical metrics on an ongoing basis: While all drawdowns are crucial, try to keep a closer eye on the Relative, Maximum, and Absolute Drawdowns. Use these to make risk-adjusted returns. 

The practices mentioned above will enable you to keep calm and collected even on days when the market conditions and the strict drawdown limits are testing your patience. And more importantly, stick to consistent positions and avoid the temptation to alter them to recoup your losses. 

Conclusion 

Drawdowns are designed to help prop firms safeguard capital and evaluate the performance of their traders. The important thing to note is that even the best of traders will at some point hit a rough patch. When these happen, you should be ready to remain calm and re-evaluate your position sizing rules. Avoid the temptation to increase your positions, as this may lead to more losses. 

At Audacity Capital, you’ll get access to an active trader community that you can rely on to remain motivated and to adhere to your drawdown limits. Don’t be afraid to reach out to fellow traders to gain insight into how they are able to remain funded.

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