Forex Trading Systems: What Is Drawdown?

When you are looking at forex trading systems, one of the factors that you might see mentioned in a good system review or summary is drawdown.

So What Is Drawdown?

All forex trading systems have their losses, as I am sure you know, and occasionally you will have several losses in a short period of time. The amount of loss that you might expect to have in a certain period varies according to the system, but it will follow statistical laws and is probably more than you think. The amount that you can expect to lose on each losing trade also varies with different systems, of course.

So there is a need for some kind of measure that will apply to any system to give you an idea of how much your funds are likely to diminish when a string of losses occurs. This is drawdown: the degree of loss between the peak value of your funds and the lowest point after a bad run.

Why Is It Useful?

Having a figure for the drawdown of a system is a very useful measure of the risk that you are likely to encounter. Clearly it depends on how much risk you are placing on each trade, so knowing this figure will help you keep your per trade risk within boundaries where your funds are not likely to be wiped out when things go against you. It gives you a worst case scenario based on past results.

If your actual loss goes to more than you have on deposit with your broker or the credit you have agreed with him, your broker will ask for more money (issue a margin call) or close your position. Having a drawdown figure for your system helps you to avoid this by making sure that your expected potential loss is covered.

Some caution is required here because you cannot assume that the past results are necessarily going to continue into the future. You should plan for a buffer, probably at least as much again. 

Drawdown is also used in calculating the Calmar ratio of a financial trading system. This the compounded annual return divided by the maximum drawdown of a system. Often, a system with high returns will also have high risk, but you can use the Calmar ratio to compare different forex systems. One with a higher Calmar ratio will have a higher return in relation to its risk and most people would consider that makes it a better system, at least on historical results.

How To Calculate Drawdown

Of course, many systems are described or sold without telling you the drawdown. Or you may be designing your own system and want to be able to assess its risk. You may wonder what to do in this situation. The answer is very simple. If the system does not tell you exactly what its drawdown is, you should try to work this out for yourself. The best way to do it is to run the system for a considerable period in a demo account. This is always a wise plan when testing a new system anyway.

As you probably know, demo accounts allow you to run a forex trading system in real time but with virtual funds so that you do not have to risk any of your own real money. Most brokers provide them and it is best to have a different demo account for each system that you are testing. This makes it easier to track results and variables such as the drawdown of your forex systems.