Daily vs Max Drawdown

Key Highlights

Drawdown rules help define by what percentage a funded account can drop when on a losing streak, including how close you’ll get to breaching the prop firm’s conditions. 

In a nutshell:

• Understanding these stop-out rules is key to avoiding account termination and losing access to the firm’s capital.
• A drawdown helps measure the trading account’s decline from peak to low – this is an important concept in managing risk.
• Different prop firms use varied drawdown limits, including but not limited to daily, maximum, fixed, and trailing.

Daily vs Max Drawdown

Drawdown rules can make or break your journey in prop trading. If you’re planning to join a prop firm or are already trading as a funded trader, this is one concept that you absolutely must master!

These rules define just how much decline is permissible for each account from its peak to its lowest. They’re, therefore, crucial for effective risk management. For a trader, understanding the rules used by each firm can have a positive impact on their consistency and profitability.

To get you started on this, we are going to guide you on the daily vs max drawdown limits and how they differ from each other. Read on to learn more about why managing drawdowns is crucial in preventing the loss/termination of a funded trader account. 

What Is Daily Drawdown?

The daily drawdown prop trading limit refers to the maximum amount that you can lose in a single day when using a funded account. The prop firm recalculates this amount daily and is often based on your opening balance. 

What this means is that the clock will reset every 24 hours, allowing you a fresh start each day!

However, you should be advised that if this were to drop below the permitted limit for the day, it would imply that you have failed the evaluation. The good news is that there’s no reason to panic, as once you understand how it works, the daily drawdown limit will become a good ally. 

Why does the daily drawdown limit matter?

• It helps keep you disciplined: The daily drawdown rules ensure you don’t trade recklessly when on a losing streak, thus encouraging you to adhere to your trading plan.
• It enables you to build professional habits: Understanding what it is and how you can manage it prepares you for real-world trading. This is a world where risk management matters the most. 
• It safeguards your progress: When you’re able to cap your losses, you get to live to trade tomorrow, even after sustaining losses on that day. 

What Is Max Drawdown in Trading?

Investors typically judge performance based on the returns offered. But the reality is that returns alone aren’t enough, as they don’t always tell the full picture. 

Why is the maximum drawdown more important than volatility 

Volatility is used to measure how much the prices have fluctuated. On the other hand, maximum drawdown in trading assists in measuring the damage brought on by these fluctuations. 

What does this mean for you as a prop trader?

• Recovery becomes harder as the drawdown grows: For example, a 10% drawdown will require a minimum of an 11% gain for you to make a recovery. 
• Drawdown reflects a lived experience: Prop traders rarely feel standard deviation. For them, it’s about the losses that they have incurred from their peak positions.

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Key Differences Between Daily and Maximum Drawdown

In prop firm challenges, daily drawdown and maximum drawdown are some of the key metrics used to manage risk and prevent unwanted losses. Others that we covered on a different post are the Fixed vs Trailing Drawdown.

Back to the topic at hand, you should note that the daily drawdown is reset every 24 hours, while the maximum drawdown serves as the cumulative limit meant to last the duration of an account. The table below helps provide the differences between the two:

Real-World Example of a Drawdown Breach

Daily and maximum drawdowns play an important role in prop trading in that they help evaluate how suited a trader is to managing the firm’s capital. Having looked at a definition of both, let’s now look at a real-world example of a drawdown:

To help us understand this, we are going to use a “temporary spike scenario” in a funded account having a $100,000 allocation.

Account size: $100,000

Trailing drawdown limit: For this account, the limit will be $3,000. The implication here is that this funded account shouldn’t drop below $97,000. 

Type of drawdown in use: the intraday trailing drawdown (this kind of drawdown shifts in real-time)

Read our complete guide on this topic daily vs intraday drawdown prop trading firms

So, what happened after trading had begun?

1. During the morning trading hours, the trader opened two long positions on the S&P 500 Futures.
2. The conditions present led to a spike, allowing the account to attain a high of $102,000, translating to a $2,000 profit.
3. In this scenario, it means that the trailing drawdown level has now shifted to $99,000.
4. When the market suddenly goes on a reversal, the trader has an option to either close their position or hold it.
5. If they choose to hold and hope for a re-entry, it means that the equity will now have dropped back to the opening balance of $100,000.
6. For the trader, it means that while they may have gone back to their starting balance, they’ll still have breached their trailing limit of $99,000. 

The result here will be account termination. This is because the trader at one point had enough equity to push their maximum allowed loss threshold up. However, the resulting loss caused them to hit that new, tighter threshold. 

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Apart from a trailing drawdown, there’s also the static, balance-based drawdown, which is the most favored by prop-trading firms.

In such a model, I have found that the prop firm will typically calculate the maximum allowable loss based on the starting account balance and the recently closed trade results.

What does this mean for you? It means that the firm will essentially ignore the floating/unrealized profits and will remain fixed even when your account makes some money. Let me use an example to better explain this:

Initial Balance: $100,000

Static Drawdown Limit (10% of Initial Balance): $10,000

Hard Breach Level: $90,000 (It means that your account can’t afford to drop below this level)

So, what happened after trading had begun?

You’ll start your trading week with a balance of $100,000 and a limit of $90,000.

During the week, your trades profit, causing the account balance to rise to a new high of $110,000.

In comes the drawdown rule. Given that the prop firm is using a static drawdown, the limit will remain $90,000 even after recording a profit through closed trades.

If you begin a losing streak and lose say $15,000 which will see you enter the drawdown phase, it means the new balance will be $95,000.

The result here is that the account is still profitable given that the balance remains comfortably above the hard breach limit of $90,000.

I have found that firms using the static, balance-based drawdown are more trader-friendly, in that they have a fixed floor that doesn’t move even when the profit levels change. Additionally, the balance-based limits tend to be calculated based on the day’s starting balance, and not the highest profit levels you have attained on a given day. 

Here’s a detailed explanation about static drawdown vs trailing drawdown

Why Most Traders Fail Here

During the evaluations, most traders fail because of a combination of reasons. Top among these are:

• Misunderstanding trailing drawdowns: Many firms use trailing drawdowns, as shown in our example above. This means your account may go into breach if a high-performing trade reverses. 
• Falling into the revenge trading trap: Since daily drawdown limits are often tight, incurring a few early losses could lead to heightened emotional pressure. This will then pave the way for revenge trading in a bid to recover from these losses. 
• Ignoring the reset structure: You need to understand that the daily drawdown has been designed as a soft stop button. Failure to do this may cause you to treat the max drawdown limit as the daily limit, leading to account termination. 

The only way to avoid breaching the daily and maximum drawdown limits is to understand what each is and what it represents. You can do this by first taking the time to learn how to manage risk during challenges. 

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Conclusion 

Mastering the daily vs maximum drawdown limits is needed for continued profitability. These limits are designed to teach you trading discipline, risk management, and capital preservation. Many traders fail the funded challenges because they’re unsure of how to navigate them, and not because they lack skill. To make sure you’ll pass the Audacity Capital challenge on your first try, make sure to start by learning how each of these limits works!

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