Lesson 8: Different Types of Drawdown in the Prop Firm Industry

In the fast-paced world of prop trading, risk management is paramount. Among the various metrics and concepts used to assess the potential losses and protect trading capital, drawdown types play a crucial role. Drawdown is the measurement of a decline in a trading account’s value from its peak to its lowest point during a specific period. It’s a powerful tool that traders, particularly in proprietary trading firms (prop firms), utilize to evaluate the effectiveness of their strategies and mitigate potential losses. In this blog, we will explore the different types of Drawdown in the prop firm industry, along with the key components of each of them.

Different Types of Drawdown in the Prop Industry

Let’s take a look at the types of Drawdown one by one.

Balance-based Drawdown

Balance-based drawdown is a concept used in forex trading to assess the risk and potential losses of a trading account. It refers to the measurement of the maximum decline in the account’s balance from its peak value, usually expressed as a percentage. Balance-based drawdown provides traders with insights into the potential loss they may experience during a specific trading period.

Key components of balance-based drawdown:

Balance. The balance represents the total funds in a trading account. This includes both the initial deposit and any profits or losses resulting from trades. It is the net amount available for trading purposes.

Drawdown. Drawdown refers to the peak-to-trough decline in the account balance during a specific period. It measures the percentage decrease from the highest balance reached to the lowest point experienced. Drawdown can occur due to losing trades or a series of consecutive losses.

Balance-Based Drawdown. Balance-based drawdown is the measurement of drawdown as a percentage of the highest balance achieved in the trading account. It provides traders with an understanding of the risk associated with their trading strategies and helps them assess the potential losses they may encounter.

How to calculate balance-based drawdown

• Identify the highest value of the trading account balance during a specific time frame. This value represents the reference point for measuring drawdown.
• Determine the lowest point the account balance reaches after the peak value. This value represents the bottom of the drawdown.
• Calculate the difference between the highest balance and the lowest balance as a percentage of the highest balance. This percentage represents the balance-based drawdown.

Balance-based drawdown is a crucial metric in forex trading risk management. It helps traders evaluate the potential downside of their strategies and determine if they are within acceptable risk parameters. By monitoring drawdown levels, traders can adjust their trading approach, position sizing, or risk management techniques to mitigate losses and protect their capital.

Equity-based Drawdown

Equity-based drawdown is another important concept used in forex trading to assess risk and potential losses. While balance-based drawdown measures the decline in the trading account’s balance, equity-based drawdown takes into account the equity of the account, which includes both the balance and the floating profit or loss of open trades.

Key components of balance-based drawdown:

• Equity represents the current value of the trading account, including both the balance and the unrealized profit or loss from open positions. It is the net value of the account at any given time.
• Drawdown, as mentioned earlier, measures the peak-to-trough decline in the account’s value during a specific period. It represents the percentage decrease from the highest equity level to the lowest point experienced.
• Equity-based drawdown is the measurement of drawdown as a percentage of the highest equity level achieved in the trading account. It considers not only the balance but also the floating profit or loss on open positions. Equity-based drawdown provides traders with a comprehensive understanding of the potential losses they may face, considering both realized and unrealized profits or losses.

How to calculate equity-based drawdown

• Identify the highest value of the trading account’s equity during a specific time frame. This value represents the reference point for measuring drawdown.
• Determine the lowest point the account’s equity reaches after the peak value. This value represents the bottom of the drawdown.
• Calculate the difference between the highest equity level and the lowest equity level as a percentage of the highest equity level. This percentage represents the equity-based drawdown.

Equity-based drawdown is a critical metric in forex trading risk management. It provides traders with a more accurate assessment of their account’s performance, considering both realized and unrealized profits or losses. By monitoring equity-based drawdown, traders can make informed decisions about position sizing, risk management, and adjusting their trading strategies to protect their capital and maintain sustainable trading performance.

Absolute Drawdown

Absolute drawdown is a concept used in forex trading to measure the overall decrease in the value of a trading account from its peak to its lowest point. Unlike balance-based drawdown or equity-based drawdown, which are expressed as percentages, absolute drawdown is expressed in the account’s base currency.

Key components of absolute drawdown:

• Drawdown, as mentioned before, represents the decline in the value of a trading account from its highest point to its lowest point. It measures the decrease in the account balance or equity, depending on the type of drawdown being considered.
• Absolute drawdown is the actual monetary amount by which the trading account’s value decreases from its peak. It quantifies the difference between the highest value of the account and the lowest value it reaches during a specified period.

How to calculate absolute drawdown

• Identify the highest value of the trading account during the specified time frame. This could be either the highest balance or equity level, depending on the context.
• Determine the lowest point the trading account reaches after the peak. This represents the bottom of the drawdown.
• Calculate the difference between the highest value and the lowest value. The result is the absolute drawdown, expressed in the account’s base currency.

Relative Drawdown/Trailing Drawdown

Relative/Trailing drawdown is a concept used in forex trading to measure the maximum decline in the value of a trading account from its peak, continuously updated as new peaks are reached. It provides traders with a dynamic assessment of the account’s drawdown, taking into account the account’s highest value at any given point in time.

Key components of relative/trailing drawdown:

• Drawdown represents the decline in the value of a trading account from its highest point to its lowest point. It measures the decrease in the account balance or equity, depending on the context.
• Relative/Trailing drawdown is the ongoing measurement of drawdown as new peaks are reached in the trading account. It captures the maximum decline from the highest value of the account up to the most recent peak.

How to calculate relative/trailing drawdown

• Identify the highest value of the trading account during the specified time frame. This could be either the highest balance or equity level, depending on the context.
• Continuously track the current value of the trading account as new peaks are reached.
• Calculate the difference between the current value and the highest value reached. This difference represents the relative/trailing drawdown.

Relative/Trailing drawdown is a valuable metric in forex trading as it provides traders with real-time information about the account’s drawdown, considering the most recent peaks. It allows traders to assess the current risk and potential losses based on the latest market conditions.

Different prop firms have different types of Drawdown. So, you need to figure out which one works best for you.