Trailing Drawdown

Key Highlights

A trailing drawdown can help in promoting better risk management, but it requires that the trader have a good understanding of its rules and psychological impact. In a nutshell:

• The trailing drawdown limit adjusts with every profit recorded
• It locks in profits, thus encouraging disciplined trading
• There are two popular types of trailing drawdowns: Intraday and end-of-day
• Your limit will remain fixed even if the balance reduces at a later date

Trailing Drawdown

A trailing drawdown is a moving loss limit that helps safeguard trading profits as the account grows. And unlike the case with a fixed drawdown, a trailing drawdown will continue to adjust upwards every time the funded account attains a new peak. 

But while profits will cause the limit to move upwards, please be advised that the same doesn’t happen with losses. Prop firms use these limits to help encourage discipline among their traders. They do this by locking in the profits, thus forcing you to adopt a more cautious approach to trading.

Besides encouraging trading discipline, a trailing drawdown also helps prop firms manage risk, while rewarding the traders who have shown consistent growth. Read on to learn more about what trailing drawdowns are and how they work. 

What Is Trailing Drawdown?

A trailing drawdown is a type of drawdown pegged to the positive performance of your funded account. The implication here is that any increase in profits will lead to an increase in the trailing drawdown limit. 

Let me use an example to explain this:

If you’re trading with a $50,000 funded account, the trailing drawdown will be $48,000. Let’s say that you manage to make a profit of $100 on the first day of trading.

The profit made will have increased the balance to a new high of $50,100. Due to this increase, the trailing drawdown will also increase by the same margin to become $48,100.

I think it’s important to note that this increase will continue until the trailing drawdown hits the account’s opening balance, which stood at $50,000. 

Once you reach this level, the trailing drawdown will cease increasing. 

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Different Types of Trailing Drawdown

Trailing drawdowns help limit trading losses by moving the account’s maximum loss threshold upward as your profits increase. The primary types of drawdowns are:

Intraday Trailing Drawdown

Prop trading firms that provide the intraday trailing drawdown tend to shift the maximum stop loss level in real time. This means that the limit can move at any time, as it doesn’t have to wait for the balance to clear after the financial markets have closed. 

Simply put, the drawdown will rise as long as the account balance is higher than before. 

The problem with the intraday trailing drawdown is that it also considers unrealized profits when making its calculations. For a trader taking the evaluation challenge, this means that you’re likely to lose your account if a previously profitable trade bounces back in profitability. 

With that out of the way, let’s now look at an example of intraday trailing drawdown:

Trading Day 1: You start with a balance of $50,000 and an intraday drawdown limit of $2,000. Your maximum drawdown limit is now $48,000.

During trading, the balance on the unrealized profits rises to $51,500, causing the stop loss level to also increase to $49,500. Because of this new increase, it means that you shouldn’t allow the balance to fall below this level during intraday.

Trading Day 2: Your trading activities lead to the balance increasing to a new high of $55,000. With this new increase, the maximum trailing drawdown will now become $50,000.

So, why does it stop at $50,000 and not $50,500? The reason for this is that the trailing drawdown doesn’t increase past the initial capital amount. However, be sure to check the terms provided by the prop trading firm to get a better idea of what to expect. 

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End of Day Trailing Drawdown

Prop trading firms that provide the end-of-day (EOD) trailing drawdown will usually move the maximum stop loss level limit up at the close of each trading day. In this case, your drawdown limit will only rise if the value of your account at the close of trading has risen to a new high. 

As someone who has had the opportunity to use the different types of trailing drawdowns available, I can confidently state that the end-of-day trailing drawdown is the best for traders. The reason for this is that in this drawdown, only the end-of-day balance will cause a change in the maximum stop loss level. 

Let’s use an example to explain how this end-of-day trailing drawdown works:

Day 1 Trading: Assuming your starting account balance is $50,000, the drawdown limit for that account will be $2,000. As such, the maximum drawdown permitted is $48,000.

During the intraday trading activities, the balance, including your unrealized profits, increases to $51,500, but then reduces to $51,000 at market close. To calculate the trailing drawdown, this is what we will do: $51,000 – $2,000 = $49,000.

Day 2 Trading: The account balance increases to $55,000 during intraday trading before finally settling at $52,500 at market close. The maximum trailing drawdown will now be set at $50,000 since this is the initial account balance. 

Static Drawdown

A static drawdown is, as the name suggests, it doesn’t trail the drawdown value, and will, instead, remain fixed at the same level where it started. 

Example: The starting balance in your account is $100,000 and comes with a maximum loss level limit of $625. In a static drawdown, the maximum allowed drawdown level will remain at $99,375 at all times, no matter the performance of your open positions. 

A static drawdown offers the following advantages:

• Live account access after reaching the objective
• Perfect for holding positions overnight and over the weekend
• No high-water mark anxiety

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Common Drawdown Calculation Mistakes

It’s not uncommon for you to encounter an issue when trying to calculate the trailing drawdown. Some of the mistakes you need to be on the lookout for include:

• Overlooking the Locking Mechanisms: Some prop firms will lock the trailing drawdown once your profits have reached a certain threshold. Read the terms and conditions from the prop firm to make sure you understand the locking mechanism, as this can impact your risk management plan .
• Misunderstanding Open Positions: The intraday trailing drawdown will normally include unrealized losses or gains from your open trade positions. Therefore, choosing to only focus on the closed trades will cause you to arrive at incorrect thresholds. 
• Combining Calculation Methods: A prop firm can either use intraday or EOD methods, and not both. Combining both methods in your calculations can lead to unwanted errors and confusion. 

Conclusion

The trailing drawdown can best be described as a flexible risk management tool that helps in promoting disciplined trading habits while safeguarding capital. How this drawdown is calculated will differ depending on the prop firm providing it and the type of account being used. For example, the end-of-day trailing drawdown will adjust when the market closes, while the intraday trailing drawdown will adjust in real time as you continue to trade. On the same breadth, there are firms that will halt the drawdown mechanism after you have attained your profit targets. Others, on the other hand, will continue indefinitely for as long as you’re trading. Understanding the differences between these types of drawdowns is vital because exceeding the limits set by the prop company will lead to account termination. At Audacity Capital , we have clear drawdown rules in place to make sure that your trading strategy will not be compromised. 

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