Drawdown is a term that is used in the Forex market to describe the amount of money that an account could lose after a streak of losing trades. Drawdown is often used to measure the money-making potential of a trading system that is used for trading the Forex market. Many times, the creators of a system will publish results from many accounts that they have tested it on.
The drawdown is essentially the percentage of your account that you have lost. After a losing streak, your account balance will be depleted by a certain amount. For example, if you had a $10,000 account and you lost $2,000, the drawdown in your account would be 20 percent.
Traders use drawdown as a way to initially compare trading systems. For example, if you found a trading system that was 90 percent profitable, it would mean that you win your trades 90 percent of the time. However, that percentage does not indicate in what order the losses occurred. In 100 trades, you might experience those 10 losses in a row. If those losses of are large and the wins are small, you could still end up losing funds to operate with.
Maximum drawdown is a statistic that is used by traders to determine the greatest amount of drawdown possible for a trading system in a given period. In order to project the maximum drawdown, traders can look back at the history of a system's trading results and see how many losing trades have occurred in a row. This will give them the potential worst-case profit-and-loss scenario for a Forex trading account.
In order to deal with drawdown, traders need to work with strict money management rules. Every time that they open a trade, they need to know exactly how much of that trade is at risk, considering the amount of drawdown the system has historically incurred. The percentage of risk, or potential monetary loss, must be added to the cost and profit of each trade.
Many traders are tempted to forget about money management when they go on a winning streak. While this is common, it is also an action that could cost in the long run.