Drawdown happens when losses in a trading account outweigh profits over a certain period. If you trade in any kind of volatile market, some drawdown is inevitable. It is one of the risks associated with putting your money into financial markets.

Drawdown becomes a serious problem though when the losses are large in proportion to the funds held in the account.

There are two kinds of drawdown:

Strategy drawdown: Strategy drawdown happens when a trading system encounters a period of losses in succession. The realization of losses causes the balance of the account to fall beneath a previous high. When strategy drawdown is deep and prolonged, it can indicate a failure in the trading system.

It can also be due to a change in market conditions such as trending or volatility, which can destabilize a weak strategy.

Example: On day 1, a trader’s account balance is $1250. On day two after closing three open positions, his balance is $1200. The strategy drawdown is $50 or -4%.

Float drawdown: Float drawdown also known as floating losses happen when the running balance of the open trading positions in an account becomes negative. The distinction between float drawdown and strategy drawdown is that float drawdown is unrealized P&L. This type of drawdown changes continually with market fluctuations.

Example: A trader’s account balance is $1250. He has one open EUR/USD position with a net loss of $100. The floating drawdown is $100, or -8%. The account equity (balance – float) is $1150.

Why Some Drawdown is Inevitable

The first thing to realize is that drawdown is a normal, if undesirable part of trading. There is no such thing as a strategy or a trader that does not experience drawdown.

Statistically, in the very first tick after opening a trade there is a 50% probability that a price will fall below the open level (ignoring spread). For the lifespan of most trades, the odds of experiencing drawdown at some point are 90% or higher. In other words, at best expect only one in ten of your trades not to experience drawdown at some point.

With longer timeframes, the chances of the price not falling below the open level are even more remote. As time increases, the odds of the price moving below (above if selling) the open increase asymptotically to 100%.

Volatility is always present in the forex market, and trying to avoid it is a bit like going to sea and expecting not to see any waves.

The psychology of losses

For many traders, dealing with drawdown is a major psychological battle. This becomes most severe when the drawdown is big enough that it threatens to bust the account.

There are two ways to look at drawdown. The optimists view and the pessimists view.

Opportunity cost: When you have open positions in drawdown, it ties up capital in your account. That represents an opportunity cost.