Your drawdown is the percentage reduction in your account balance, compared with the highest peak it has previously reached.
Trading Truth 136
"Drawdown tells you
how much risk you're taking."
By looking at the highest drawdown you have experienced, you can get a good indication of whether you are risking too much on your trades.
This is a comparative calculation because it is the percentage of your account balance that you risk on a trade that is important - not the actual amount in dollars.
Generally speaking, the lower your balance is allowed to go, the harder it will be to get it back to where it was. If your balance is halved, you will have to double it to get back to where you were.
Of course, every losing trade reduces ("draws down") your balance and if you are staking a large proportion of your equity on each trade, you are taking high risks.
But how large is large and how much should your account be expected to draw down?
This is a subject to which professional traders pay a great deal of attention.
First of all, the maximum amount allowed by a trader depends on his own
personal attitude to risk. There will be a limit beyond which he is not prepared to go - no matter what the return might be.
The evaluation method he uses must guide him in setting realistic tolerance limits within which he will be comfortable trading.
Whatever the trader decides is his 'drawdown limit' he will certainly not be prepared to take risks up to that limit if the prospective return is not there.
Any risk must be justified by the 'return on offer'. This whole aspect of risk control is covered when the trader evaluates any system to confirm it is capable of meeting his goals for risk and return.
Well in advance of trading a new system, the trader will establish its risk resonance so that the appropriate risk-per-trade parameters can be incorporated.
Waiting for live trading drawdown reports to assess his risk exposure would be leaving things far too late!
Copyright David Bromley 2006
All Rights Reserved.