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 from initial balance, regardless of profits.
2. Trailing Drawdown
• Definition: A dynamic loss limit that moves up as a trader's equity increases, locking in gains. The trailing drawdown stops adjusting when it reaches a defined threshold of your initial balance and serves as the maximum allowable loss from that point onward.
• How it Works: The drawdown limit increases as the account’s equity grows, but doesn’t decrease with losses.
Example 1: If you start with a $10,000 account, your maximum drawdown will be 5%, which is $500. The account equity should not fall below $9,500 at any time.
Example 2: If your account equity grows to $10,400, your max trailing drawdown will now be $10,400 - $500 = $9,900. The account equity should not drop below $9,900 at any point.
Example 3: If your account equity reaches $11,500, your maximum trailing drawdown will be locked at $10,000. Your account should never fall below $10,000 in equity or balance.
Static vs. Trailing Drawdown: Pros and Cons
Drawdown Type: Static
Advantages:
Predictable and fixed loss limits.
Encourages disciplined trading.
Challenges:
Does not adapt to equity growth.
Limits flexibility for aggressive strategies.
Drawdown Type: Trailing
Advantages:
Adjusts with equity growth.
Greater flexibility for profitable accounts.
Challenges:
Requires constant monitoring.
Higher risk during market volatility.
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