Drawdown and Risk/Reward Ratio: The Danger of a Losing Streak
admin on August 26th, 2008
Drawdown and risk/reward ratio are two parameters to always keep in mind when trading forex, as they indicate your risk factor for your open trades in a very precise and clear way.
Even if you feel very confident about your trading strategy, using one that results in a gain, say, 65% of the time, Murphy’s Law (which is not just a cute joke, as it can be mathematically proved) says that sooner or later you’ll incur in a losing streak. It’s important to keep these chances to a minimum by using a proper risk/reward ratio and, when a losing streak happens, to keep drawdown in serious consideration before you place your next trade.
Drawdown and Maximum Drawdown in Forex
Let’s say you lose a series of trades which bring your equity from an initial $10,000 to just $6,666.66. You lost 33 % of your account, but how much do you have to get back to where you started from, relative to your current account?
If you answered 33 %, you are wrong. The actual percentage you have to earn back is 50 %: in fact, $6,666.66 x 150% = $10,000, while $6,666.66 x 133 % = $8866.66. In other terms, you faced a 50-33 = 17% drawdown.
Let’s see what happens if you continuously lose 20 % and win 20 % of your account.
| Trade 1 | $10,000 |
| Trade 2 | $8,000 |
| Trade 3 | $9,600 |
| Trade 4 | $7,680 |
| Trade 5 | $9,216 |
| Trade 6 | $7,372.8 |
| Trade 7 | $8,847.36 |
| Trade 8 | $7,077.88 |
| Trade 9 | $8,493.46 |
| Trade 10 | $6,794.77 |
Do you see where it’s going? Due to drawdown, alternately winning and losing 20% (or any other percentage) of your account is not enough at the end of the day. This holds true even if you started with a winning trade — it would just take a bit longer.
As we hope you realized, recovering from a consistent loss, in forex like in any other form of investment, gets increasingly harder. This is why you need to try avoiding serious drawdown by using an adequate risk/reward ratio.
Risk/Reward Ratio in Forex
A risk/reward ratio is, like the term suggests, the ratio between the expected maximum loss and the maximum gain. The great thing about forex trading is that you can decide your r/r with absolute precision by placing appropriate stop losses and take profits.
For instance, if you place your stop loss at 20 PIPs and your take profit at 40 PIPs, your r/r is 1/2. Please note that some say “reward/risk” ratio, so in this case the r/r would be 2: always make sure of what others mean, unless it’s obvious from the context.
What is a good r/r ratio? If you understood what we just said about drawdown, you know that a ratio of 1 is not going to work in the long term! In fact, drawdown is precisely the reason why you should always enter trades with a stop loss tighter than your take profit.
As an example, if you use a risk/reward ratio of 1/2 and your strategy lets you win 50% of your trades, here is what your account will look like after alternately winning 20% and losing 10% of your account:
| Trade 1 | $10,000 |
| Trade 2 | $9,000 |
| Trade 3 | $10,800 |
| Trade 4 | $9,720 |
| Trade 5 | $11,664 |
| Trade 6 | $10,497.6 |
| Trade 7 | $12,597.12 |
| Trade 8 | $11,337.41 |
| Trade 9 | $13,604.89 |
| Trade 10 | $12,244.40 |
Of course, entering in trades at random won’t give you a 50% chance of winning, because the profit target is more distant than the stop loss (and don’t forget you have to factor in the spread, too): however, with the help of tools from technical analysis and a bit of experience, coming up with a strategy to earn this figure is certainly feasible.
