The maximum drawdown you should accept depends on your trading goals, risk tolerance, and strategy. Generally, traders aim to keep drawdowns within 10-20% of their account equity to ensure the sustainability of their trading capital. For professional or conservative traders, acceptable drawdowns might range from 5-10%, while more aggressive traders may tolerate drawdowns up to 30%. The key is to align your maximum drawdown with your overall risk management plan and ability to recover losses.

Understanding Maximum Drawdown

Maximum drawdown (MDD) is the largest percentage decline in account equity from its peak to its lowest point before recovering. It measures the worst-case loss during a trading period and reflects the risk of your strategy.

For example:

• Starting balance: £10,000
• Peak balance: £15,000
• Lowest balance after the peak: £12,000
  Maximum drawdown = ((£15,000 – £12,000) / £15,000) × 100 = 20%.

Factors Influencing Acceptable Maximum Drawdown

1. Risk Tolerance:
   Conservative traders may set a lower drawdown threshold, such as 5-10%, while aggressive traders might accept up to 30%.
2. Trading Strategy:
   • Scalping and day trading: Typically lower drawdowns due to frequent but smaller trades.
   • Swing trading and trend following: May have higher drawdowns due to longer holding periods.
3. Capital Size:
   Smaller accounts may require stricter drawdown limits to preserve capital for future trades.
4. Recovery Rate:
   The deeper the drawdown, the harder it is to recover. For instance:
   • 10% drawdown requires an 11% gain to recover.
   • 50% drawdown requires a 100% gain to recover.
5. Market Volatility:
   Higher volatility may lead to larger drawdowns, especially if stop-loss levels are set too tight or too wide.

How to Determine Your Maximum Drawdown

1. Assess Risk Appetite:
   Determine how much loss you can tolerate emotionally and financially without deviating from your trading plan.
2. Backtest Your Strategy:
   Analyse historical performance to understand the typical drawdowns of your strategy and adjust your limits accordingly.
3. Set Risk Limits Per Trade:
   Risk only 1-2% of your account equity per trade to prevent large drawdowns from compounding.
4. Use Stop-Loss Orders:
   Always use stop-loss levels to cap losses on individual trades.
5. Monitor Performance:
   Regularly review your account balance and drawdown levels to ensure they remain within acceptable limits.

Step-by-Step Guide to Managing Drawdown

1. Define Your Threshold:
   Set a maximum drawdown percentage (e.g., 10-20%) and stop trading if this level is reached.
2. Incorporate Position Sizing:
   Adjust position sizes to manage risk and prevent excessive losses on individual trades.
3. Diversify Your Portfolio:
   Trade uncorrelated currency pairs to reduce the impact of losses in a single market.
4. Implement a Cooling-Off Period:
   If drawdown approaches your limit, pause trading and review your strategy to avoid revenge trading.
5. Adjust Strategies for Volatility:
   Modify risk parameters based on current market conditions to prevent excessive drawdowns.
6. Maintain a Trading Journal:
   Track drawdowns, evaluate mistakes, and refine your approach to minimise future risks.

Practical and Actionable Advice

• Stick to Your Plan:
  Avoid increasing your drawdown threshold out of desperation during losing streaks.
• Focus on Risk-Reward Ratios:
  Maintain favourable ratios (e.g., 1:2 or higher) to offset losses and recover drawdowns more efficiently.
• Use Automation Tools:
  Leverage trailing stops and automated trading systems to manage risk without emotional interference.
• Set Daily or Weekly Loss Limits:
  Establish short-term loss caps to prevent escalating drawdowns during volatile periods.

FAQs

What is maximum drawdown in trading?
Maximum drawdown is the largest percentage decrease in account equity from its peak before recovering.

What is a good maximum drawdown percentage?
A good range is 10-20%, but this varies based on individual risk tolerance and strategy.

How do I calculate maximum drawdown?
Maximum drawdown = ((Peak equity – Lowest equity after peak) / Peak equity) × 100.

Why is maximum drawdown important?
It measures the risk of a trading strategy and helps assess its sustainability during losing streaks.

How does drawdown affect recovery?
The larger the drawdown, the harder it is to recover. A 50% drawdown requires a 100% gain to return to the original balance.

What’s the difference between absolute and relative drawdown?

• Absolute drawdown: Largest drop from the initial deposit.
• Relative drawdown: Largest percentage drop from the equity peak.

How can I minimise drawdowns?
Use stop-loss orders, diversify trades, reduce position sizes, and maintain a disciplined approach to trading.

What should I do if I reach my drawdown limit?
Pause trading, evaluate your strategy, and identify mistakes before resuming.

Is a higher drawdown always bad?
Not necessarily. Some strategies, like trend following, may naturally experience higher drawdowns but still achieve profitability.

Can I recover from a large drawdown?
Yes, but recovery becomes more challenging as drawdowns deepen. Focus on disciplined trading and effective risk management.

Conclusion

The maximum drawdown you should accept depends on your risk tolerance, strategy, and goals. By setting clear drawdown limits, managing risk effectively, and adhering to a disciplined approach, you can protect your capital and achieve sustainable trading success. Unlock your full potential with our expert-led trading courses. Gain insights, learn winning strategies, and take control of your trading journey today.