Levels of Drawdown – Discussion of Risk to Reward

This is something a new trader may not want to hear, but an important psychological part of trading is to understand that unless a trader has a big enough account to weather adverse market moves, the capital in one’s account should be considered risk capital. This is particularly the case for Forex since traders, depending on one’s leverage options, can and should be ready to lose all the capital in his or her account. Of course, in reality a trading plan is designed to do just the opposite, not to lose money. When beginning a trading plan, another step for a trader is to determine the psychological level of drawdown on the account that one is willing to tolerate.

An aggressive trader may be willing to take on bigger risk to potentially get a larger reward. For example, he or she may be ready to face a drawdown level of 50% of the capital in an account in order to try and achieve certain results. A conservative trader on the other hand may only be willing to get a smaller reward but will risk, for example, only 10% of the account. These numbers are not meant to be taken literally, they are just used here to highlight that some traders may have a bigger appetite for risk while others are more conservative.

Why is the topic of potential drawdown being discussed? It should be understood that if one’s trading is generating losses, instead of returns, and the account is approaching a trader’s maximum drawdown level, it means that something is wrong with the trading approach or tools. It may be time to stop trading and re-evaluate the analysis that the trader is using.

It is perfectly normal to lose on any particular trade, but it is a serious warning when there are consecutive losses and the losses add up to a large part of a trader’s account. Small losses are part of the trading plan, as some positions will end as losers and others will be winners; what is important is to have an average between the two that is positive. This means that the winners are bigger than the losers and an account is building equity.

Per Trade Exposure

A trader’s maximum operational drawdown is linked to the money management technique: per trade exposure. Per trade exposure is a technique in which there is a certain amount of capital that a trader is willing to allocate per trade. This means that there is a certain amount of risk per trade that the trader is willing to assume.

Many new traders think that if they see a potential trade, they can risk a substantial part of their capital to get a large return. One of the recipes to disaster or failure in trading is when a beginner trader tries to get rich quick; to make a fortune with one or two trades. One should aim to trade with consistency, and on average win more than you lose.

Let’s say that a trader, has a $10,000 dollar account and wants to allocate 5% of his account per trade. This means the trader is willing to risk losing $500 on any one trade. If a position goes against him by 5% of his account then according to his per trade exposure he should close it. When a trader has a specific per trade exposure amount it forces him or her to use discipline, limiting the effect of emotions on trading decisions.

Again, the numbers that are being used here are strictly to build an example and should not be used literally. If one is unsure what amount to allocate per trade, they should seek the advice and guidance of a financial advisor.

An Example of Calculating Risk using Exposure per Trade

In this example, the trader is a trend follower trading forex. They want to enter on currency strength when they see a new uptrend forming as price approaches a new high at 1.2575.

Let’s assume that from looking at support levels beforehand they made the conclusion to place a stop somewhere around 1.2480, which is a difference of around 100 pips.

If they have a $20,000 account and their exposure per trade is 5%, they can risk $1,000 on a given trade. If they prefer to open 1 Lot positions, the 100 pip difference from where they want to open the trade to the stop fits with the 5% requirement. Therefore, the amount from 1.2575 to 1.2480 is now considered the risk after opening the position.

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As long as price stays within the 100 pip risk zone, it will be considered noise. If the pair moves to 1.2480, the original analysis was wrong and the stop loss order they placed earlier should close their position.