What Are Drawdowns in Prop Trading?
Picture this: A drawdown is the decline in an account’s equity from its peak to its lowest point during a trading period. It’s a vital risk metric, influenced by factors like market volatility, trading techniques, and risk management.
Key Drawdown Types in Prop Trading
Prop firms generally enforce either a static (balance-based) or trailing (equity-based) drawdown. Each type has its unique rules, benefits, and challenges.
Let’s explore:
1. Static Drawdown
- Definition: Also known as a balance-based drawdown, it’s determined by the account’s initial balance.
- How it Works: The drawdown is fixed, calculated as a percentage of the starting capital. Example: If a firm enforces a 10% static drawdown on a $15,000 account, the maximum allowable loss is $1,500, regardless of profits.
2. Trailing Drawdown
- Definition: Trailing drawdowns adjust based on the account’s equity.
- How it Works: The drawdown limit increases as the account’s equity grows, but doesn’t decrease with losses. Example: For a $25,000 account with a 5% trailing drawdown, if the equity peaks at $30,000, the maximum allowable loss becomes $1,500 above the initial balance ($25,000 + $1,500 = $26,500).
How to Calculate Drawdowns
Static Drawdown Formula
Static Drawdown = (Initial Balance - Lowest Balance) / Initial Balance x 100%
- Example:
Initial Balance: $12,000
Lowest Balance: $10,500
Static Drawdown: ($12,000 - $10,500) / $12,000 x 100% = 12.5%
Trailing Drawdown Formula
Trailing Drawdown = (Highest Equity - Current Equity) / Highest Equity x
100%
- Example:
Highest Equity: $18,000
Current Equity: $16,500
Trailing Drawdown: ($18,000 - $16,500) / $18,000 x 100% = 8.33%
Static vs. Trailing Drawdown: Pros and Cons
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