6 Types of Drawdown in Trading

There are primarily 6 types of drawdown in trading. Drawdown is defined as the reduction in an account’s equity level after losses. It is a critical metric that is used among prop firms to measure risk, evaluate trading performance, and most importantly, ensure capital preservation. Understanding the various types of drawdown can assist traders in managing risk better and respecting drawdown limits that prop firms implement.

1. Absolute Drawdown: Types of Drawdown in Trading

Absolute drawdown is a measure of the difference between the starting balance of an account and its lowest equity point during a specific period. Absolute drawdown focuses on the initial capital loss rather than losses from the peaks in equity.

Example:

Starting balance: $100,000

Lowest equity: $95,000

Absolute drawdown: $100,000-$95,000=$5000

2. Relative Drawdown: Types of Drawdown in Trading

Relative drawdown measures the percentage decline from the highest equity point of an account during a trading period. Relative drawdown includes account fluctuations as the account grows (or declines). Peak equity refers to the highest equity in a trading period, whereas trough equity refers to the lowest equity in a trading period.

Example:

Peak equity: $50,000

Trough equity: $42,000

Relative drawdown: $50,000-$42,000= $8000 / $50,000 = 16%

3. Daily Drawdown: Types of Drawdown in Trading

Daily drawdown measures the largest equity decline within a single day. This metric is commonly used among prop firms as the high majority of prop firms use a daily drawdown metric to enforce strict risk management.

Example:

Start of day equity: $103,000

Lowest equity during the day: $97,000

Daily drawdown: $103,000-$97,000= $6000

4. Maximum Drawdown: Types of Drawdown

Maximum drawdown is the largest peak-to-trough decline in an account’s equity during a specified period.

Example:

Peak equity: $109,000

Trough equity: $93,000

Maximum drawdown: $109,000-$93,000= $16,000

5. Floating Drawdown: Types of Drawdown in Trading

Floating drawdown refers to unrealized losses on open positions. It represents the equity decline while trades are active, but not closed. This type of drawdown in trading fluctuates as the market moves. Some prop firms have floating drawdowns in their rules as it can be an indicator of a trader taking on too much size in their positions.

Example:

Account balance: $100,000

Open trades: -$4600

Floating drawdown: $100,000-$4,600= $95,600

6. Equity Drawdown: Types of Drawdown in Trading

Equity drawdown tracks the decline in account equity, including realized and unrealized losses. Equity drawdown provides a clear picture of the account’s health, combining closed and open positions. This type of drawdown in trading is crucial to determine the state of an account’s risk exposure when taking on trades.

Example:

Account balance after closed trades: $100,000

Floating equity (including open trades): $96,000

Equity drawdown: $100,000-$96,000= $4000

Conclusion: Types of Drawdown in Trading

Understanding these various types of drawdown in trading should be fundamental knowledge for all traders, especially when taking on a prop firm challenge. These drawdowns are crucial to understand not only part of a strong risk management plan but also to understand prop firm drawdown rules to prevent traders from blowing an account. When traders are able to manage drawdown, they can preserve their capital, improve consistency, and ultimately be a successful trader in the financial markets.

Frequently Asked Questions: Types of Drawdown in Trading

What is the difference between absolute and relative drawdown in trading?

Absolute drawdown measures the loss from the initial account balance to the lowest equity point of the account; whereas, relative drawdown measures the percentage loss from the account’s peak equity to its lowest point during the trading period.

What is the difference between floating and equity-based drawdown in trading?

Floating drawdown refers to the unrealized losses on positions that are open; whereas, equity-based drawdown considers unrealized and realized losses on positions.

How can traders manage drawdown in trading effectively?

Setting stop losses, position size calculator to use appropriate position sizes, avoid over leveraging, and focus on a strict risk management and trading plan. View our programs here and get funded today!