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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.

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:

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.

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Forex Definitions: Stop Loss, Take Profit and Trailing Stop Orders

admin on August 22nd, 2008

In the world of currency investing, the three terms “stop loss”, “take profit” and “trailing stop” are widely used, since they are the best known kind of limit orders that are used to close a trade under specific conditions, allowing the investor to greatly reduce its risk exposure and trade with more serenity.

A Few Initial Assumptions

For explanation purposes, let’s make the following assumptions:

• we went “long” on a standard 100,000 EUR/USD lot on a USD account, which means buying $100,000 worth of EUR;
• the current EUR/USD bid price is 1.500, which means we bought €66,666.67 (that is, $100,000 worth of EUR).

As we already explained, a PIP is defined as the minimum variation that can occur in a trade, which is 0.001 for EUR/USD as well as most of the other pairs. We can calculate the value of a PIP for any given trade by multiplying 0.001 to $100,000 and see that any minimum variation gives us a profit or a loss of exactly $10.

Since the forex market is extremely volatile, we want a way to protect our investment: luckily, we can do this with stop, limit and trailing stop orders.

Stop Loss Orders in Forex

A stop order is a way to protect ourselves in the worst-case scenario. Setting it at a distance of -20 PIPs, for instance, means (under the conditions explained above) that for this particular trade we won’t be losing more than $10 x 20 = $200. You’ll find it extremely useful to be able to precisely monitor the risk exposure of all your open trades.

Take Profit (or Limit) Orders in Forex

Conversely, a take profit (or limit) order is a way to somehow “save” your profits, meaning if you reach a certain ask price, you will automatically sell. If you for instance set a limit at a value of +40 PIPs, you’ll know the maximum you can profit from a trade is $10 x 40 = $400.

Placing a limit order is extremely important as it helps you keeping your trade objectives clear for all of its duration and avoids the (very realistic) possibility that greediness will take over and damage your trade. If you don’t have a clear objective from the very beginning, you’ll never want to close a trade since you’ll be constantly looking for more and more profits, but chances are you won’t want to close it even when the pair has made its peak and started to retrace, eventually leading you to lose on a potentially positive trade.

Trailing Stop Orders in Forex

A trailing stop order is another interesting possibility, very useful especially in volatile markets. Let’s suppose you placed a trailing stop at 1.510, and the pair initially goes at 1.515, then makes a swing back at 1.480, when your stop and limits are at 1.490 and 1.520 respectively. What happens here?

Without a trailing stop, you would exit the trade with a stop loss at 1.490, losing $100. But with a trailing stop, you would profit $100 under exactly the same conditions! A trailing stop is triggered when the pair price reaches a certain value, 1.510 in our example, and replaces the former stop loss.

That way, when the pair reaches 1.510, the trailing stop is triggered and somehow “saves” your profits, triggering a stop loss exit in case the pair starts going down from there, and of course the limit order otherwise.

As we hope you realized, using stop, limit and trailing stops often makes a difference between a good and a bad trade, and learning how to use them profitably is an essential part of your training as a forex investor.

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