One of the most important concepts to understand in forex trading is “drawdown.” This term refers to a decrease in the value of your trading account from its highest point, usually expressed as a percentage. While some drawdowns are normal in trading, the risks associated with significant drawdowns can be severe and even devastating. In this article, we will examine why Forex drawdowns are so dangerous, why averaging a losing position is risky, and how it differs from the stock market, where traders have more options to settle losses.
What Is Drawdown, and Why Is It Important?
A drawdown occurs when you lose money on your trades, causing your account balance to drop. For example, if you start with $10,000 and your account goes down to $7,000, you are facing a drawdown of 30%. The problem with forex drawdowns is that the high leverage of the market can cause even small price fluctuations to cause large swings in the value of your account.
Leverage allows traders to control large positions with relatively small amounts of capital. This means you can take on much more risk than planned. When trades are in your favor, leverage increases your profits, but if the market moves against you, it also increases your losses. Understanding and managing drawdowns is crucial for anyone who trades Forex, especially in currencies.
The Real Dangers of Drawdowns
The bigger the drawdown, the harder it is to recover. When your trading account drops significantly, recovering your losses is not just about returning what you lost. For example, if your account is down 50%, you need to make a 100% profit to return to where you started. This can be like climbing a steep hill, and it often causes traders to take on even more risk to recover quickly, leading to a vicious cycle of further losses.
When drawdowns occur, traders typically feel stressed, anxious, and frustrated, which can lead to impulsive decisions. Instead of following a well-thought-out strategy, you may chase losses or abandon your trading plan altogether. Emotional stress can exacerbate the situation and cause small losses to turn into large, account-destroying losses.
You will receive a margin call if your account equity falls below a certain level due to drawdowns. This means that you will need to fund your account to keep your positions open. If you are unable or unwilling to do so and the drawdown reaches the stop-out level, the broker will close some or all of your trades, which may result in large losses or total loss of your deposit.
The Trap of Averaging Down a Losing Position
One strategy many traders try when in a losing trade is averaging a losing position. The idea is to buy more of a currency pair that is losing value or, conversely, sell more if the price is rising in the hope that the market will eventually reverse. You can compensate for your early losses by exiting the trade with a smaller loss or profit. While this may seem sensible, it carries significant dangers in the Forex market.
Averaging a losing trade can quickly lead to excessive risk-taking, especially when leverage is used. Each additional position added to a trade increases the potential for loss if the market continues to move against the trader. As risk increases, so does the potential for catastrophic drawdown, which can wipe out an entire deposit.
Adding to a losing position also increases margin requirements, which means more capital is required to maintain open positions. If the market continues to move in an unfavorable direction, traders may face margin requirements sooner than expected, leading to forced liquidation at unfavorable prices.
The most dangerous aspect of averaging is the possibility of rising drawdowns. If the market trend continues against the position, the trader is left with a larger losing position. Increasing drawdowns makes recovery more difficult and can trigger an emotional reaction that leads to even more risky behavior on the trader’s part.
If the market doesn’t turn around, you won’t just be left with a losing position; you’ll be left with an even bigger position. The deeper the drawdown, the harder it will be to recover, especially if you take on more and more risk as you average down.
Drawdowns in the Stock Market
Interestingly, averaging down is less risky in the stock market. Why? Lower leverage makes it less risky. In the stock market, traders typically use much lower leverage. For example, the maximum leverage in the US for stock trading is usually around 2:1. Sometimes, you can find brokers who offer more professional investors a leverage of 5:1.
But this is still not comparable to Forex, where leverage can be as high as 2000:1, or even 3000:1 for currencies and metals, which is hundreds of times higher than in the stock market. With lower leverage, your losses (and gains) are less extreme, so adding to a losing stock position is less likely to get out of hand. Notably, in the forex market, a trader can reduce his leverage on his own, even down to 1:1, but, in practice, poor discipline, greed, and risk aversion lead traders to use leverage to the maximum.
Options help manage risk: Stock traders can use instruments such as options. Various combinations of options allow them to manage risk more effectively by hedging their losing position or receiving premiums when the price moves against the main position. In Forex, options are rare, although they do exist. However, as a rule, retail traders do not use them to hedge, making it difficult to manage the risk of averaging.
Stocks have intrinsic value, while currencies do not. When you buy shares in a company, you are investing in a business with real value, which can make averaging down a smart strategy if you believe in the company’s long-term potential. On the other hand, currencies have no intrinsic value — they are always traded in pairs, which means the value of one currency is relative to another. Therefore, betting on a currency “recovery” is not the same as betting on a company reversal.
Final Thoughts
Drawdowns are a reality in forex trading, and understanding their dangers is essential for those who want to trade successfully. High leverage can cause small losses to turn into large losses very quickly, and psychological stress can lead to bad decisions that only worsen the situation. Averaging strategy may seem like a way to recover from losses, but it is more of a gamble than a sound trading strategy in the Forex market.
In comparison, stock traders have more tools at their disposal, such as lower leverage and options, which can help manage the risks associated with averaging. For forex traders, the key to dealing with drawdowns is strict risk management, such as setting stop losses, avoiding excessive leverage, and not letting emotions dictate trading decisions.
