By: Terry Allen
If you were to lose 50% of your account on a single trade, going from $10,000 to just $5,000, as a result of an unexpected market move, you would then need to gain 100% just to recoup your initial position. This is known as a drawdown and it can have an insidious effect on your account balance.
For example, assume your initial balance was $10,000 and your results over 10 trades were alternatively 20% loss and 20% win:-
$10,000; $8,000; $9,600, $7,680, $9,216; $7372; $8847; $7,077; $8,493; $6,794
As a result of the draw-down effect, recovering from consistent loses gets increasingly harder. You need to avoid these situations developing by using a well-constructed Risk:Reward ratio which simply expresses the quotient of maximum risk and maximum reward from a single trade.
This is best achieved by gaining a thorough understanding of Money Management Strategies. One of which could state that the maximum percentage of your available account balance that will be risked on any one trade is 2%.
Knowing this value, you can then set your Stop-Loss so that should the trade go against you , you will only lose a maximum of 2% of your account.
You then need to determine your target limit so that your risk:reward will be at least 1:2 so that you can counter the effects of draw-down.
However, this will mean that your target will be at least twice the distance away from your entry point than your stop point.
You need to increase the chances of your trade hitting your target more times than your stop. To do this you will need to devise a trading system with a high win:loss ratio and expectancy value. You should gain confidence and trust in your system’s underlying strategy by back-testing historical data preferably using automation if possible.
What is a good risk:reward ratio? As already shown, a ratio of 1 is not going to work in the long term because of the draw-down problem! In fact, drawdown is precisely the reason why you should always enter trades with a stop loss tighter than your take profit.
As an example, if you use a risk:reward ratio of 1:2 and your strategy lets you win 50% of your trades, here is what your account will look like after alternately losing 10% and winning 20% of your account:
$10,000; $9,000; $10,800; $9,720; $11,664; $10,497; $12,597; $11,337; $13,604; $12,244
From these results, you can now see that you have mitigated the draw-down problem. Whilst performing your back-testing, one of the parameters that you will need to pay close attention is the historic frequency of draw-downs. When testing your strategy automatically, you must ensure that it is capable of producing profits by reducing draw-downs by the accurate placement of Stop-loss and Target-Levels.
Trading a live account is a very different experience from using a demo account. Emotion and psychology increasingly influence the trader’s decisions creating losses through bad choice selections.
For this reason, it is very important to always set Stop-Loss and Target-Limit for each trade preferably under the guidance of a strong and sound Money Management Strategy.
Once achieved, a risk:reward ratio needs to be determined with a value of at least 1:2 altogether with a win:loss ratio preferably greater than 80%. This is best achieved by creating an automated trading system based on a set of consistent rules that have been extensively back-tested.
So in conclusion, the Forex is a very complicated business and trading is certainly not easy. The Forex Market is just too complex to be taken lightly as it involves many powerful factors and forces that can produce dramatic effects on the daily fluctuations of currency pairs. Unfortunately, neither technical nor fundamental analysis can forecast the Forex Market with consistent accuracy. Drawdowns are certainly a problem that can arise as a result.
To overcome and control all these this problem, you need to develop a trading system based on a strategy that encourages the use of a set of consistent rules. You then need to gain confidence in its use by calculating its key profit-predicting parameters. This is best done by back-testing historical data. You also need to, somehow, prevent your emotions from influencing your trading decisions. Automation is a great way of doing this.