Percentage decline in the account equity is called “Drawdown.”
Stop loss order (SL) is classified as exit order. Once triggered, it closes your trade at the pre set stop price level known as SL order to control the losses.
Under the risk management topic, we already covered the important topic of “Diversification.” The second most important aspect of risk management, which is drawdowns, will be covered in this topic.
We cannot ignore that losses in FX trading happen from time to time. There are basically two levels on which losses impact a trader’s performance:
1-Psychological impact of losses
Percentage decline in the account equity is called “Drawdown.” So, for example, if you lose 3% of your account capital after one or a few losing trades, your account drawdown now equals 3%.
Take reasonable risk accordingly
Have proper risk management in place
Have strict rules on risk level and position sizing
Constantly Learning and adopting
A clear strategy in place
Patient, rational and realistic
Discipline and hardworking
High-risk trader/a gambler
Have no risk management
Risk level and position sizing are decided based on emotions
"Holy grail" forex mentality
Fascinated by the get-rich-quick hype in trading
Jumps from strategy to strategy/No patience
Why is it so important?
One must consider that as the drawdowns become bigger, it becomes increasingly difficult to recover from them. For example, when you lose 10% of your account balance, you have only 90% of your initial balance to trade with. And because of the smaller capital, now you need to generate a higher return on the reduced capital to undo that drawdown.
However, things can get very ugly once the drawdown becomes too large. In fact, if you lose 50% of your capital due to excessive risk-taking or reckless trading, you need to generate a 100% return with the remaining 50% capital that you have left to climb back to the start.
Besides that, larger drawdowns tend to weaken a trader’s discipline. Many traders begin to trade more sloppily after losing 15% to 20% of their capital. It is a vicious cycle of risk-seeking trading behavior, where a losing trader is psychologically driven to take higher risks as the difficulty of the recovery increases exponentially.
How to protect the account capital and prevent large drawdown?
In forex, your capital is your weapon to fight in the market. Therefore, protecting the capital is significantly important. Thus, It is important to implement a proper risk management strategy that consists of:
Right position sizing (will be covered in the next post)
Correct and wise Diversification. (Refer to the previous post for tips and tricks)
Having Strict Exit Strategy (Refer to the ATR post for tips and knowhow)
Use of Scaling out Strategies, e.g., trailing Stops.
In the next topic, we will cover another important topic of RM (Position sizing).
After all, trading is like running a business; if the costs get out of control, the business can sink and go bankrupt. Thus, to stay successful in the business of forex trading, you have to treat just like any other business, control your losses, and protect your capital. A trader must first learn to protect his account capital in forex trading, and protecting it must be the priority. Unfortunately, many amateur traders only think about making money once they start trading and completely ignore the importance of capital and risk management by taking excessive risks to fulfill their "holy grail" mentality.