The Key to Money Management: Knowing Your Maximum Drawdown

Filed under: Learn Forex Trading |

One of the keys to successful money management is knowing what your maximum drawdown is. However this is a bit of a catch-22 situation. Let me explain…

 

Over a testing period, you might have a virtual bank of 10,000 GBP, and you risk 1% on each trade that you make. This sounds like a good level of risk, but you should still test your methodology thoroughly before going live with it. The main reason for the test is of course, to see if your methodology is profitable or not. But there are other reasons too. One of those reasons is to try to gauge how much your maximum drawdown might be. Take a look at Figure 1 so I can talk you through a real-world example.

 

Over a testing period of 157 trades, I made a little over 4000 GBP profit starting from a bank of 10,000 GBP, which is a 40% return on investment. However, in order to protect your bank in the future, it is imperative to know what your maximum drawdown is. During this test, the maximum drawdown was around 1400 GBP, or 14%. This is not bad, but as it was such a short test, you can expect this maximum drawdown to be beaten at some point. Although we cannot know for certain exactly what that maximum drawdown might be, we can put a rough estimate on it, and I would say around double what it was in the test – so around 28%. This is an acceptable level of drawdown, so I am sticking with my 1% risk per trade for now. Had the drawdown been more, I may have lessened my risk to 0.5% per trade; and if at some time in the future I have a drawdown of over 35%, I may indeed lower my risk levels.

 

In summary, it is always important to protect your bank and know your maximum drawdown so that you can know what acceptable levels of risk are on each trade. Know this, and have a good methodology, and you have a good chance of being a successful trader.

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