August 18, 2023

On the Forex market, as with any financial market, traders face a series of challenges. One prominent challenge is the deposit drawdown. It's an inherent aspect of trading, and almost every trader will experience it. While some may face drawdowns more frequently than others, it's an unavoidable situation for all. Recognizing its inevitability and mentally preparing for it is crucial. Moreover, having a pre-established strategy to recover from these setbacks is essential; otherwise, you run the risk of wiping out your entire deposit.

What is Drawdown?

A drawdown refers to a decline in the value of an asset at a specific point in time. Put simply, you might open a position, say a buy order, but instead of the price rising, it begins to move against you. As the price drops, so does your morale, as you watch the balance of your trading account decrease.

What can be done to avoid such a scenario, or at least minimize its adverse effects? Established guides offer the following recommendations on this matter:

1. Assess Your Strategy: Perhaps you haven't accounted for specific market situations. Test your strategy on a demo account. If it results in losses, identify the reasons and make the necessary adjustments.

2. Manage Risks: Never risk too large a portion of your deposit. It's commonly recommended to risk no more than 1-2% (and at most 5%) of your deposit on a single trade.

3. Use Stop Loss Orders: Place them concurrently with opening a position. These orders will automatically close a losing trade once a certain loss level is reached.

4. Diversify: Spread your investments across different instruments to reduce the overall risk of your portfolio.

5. Never Stop Learning: The market is always evolving. Thus, a trader should consistently update their knowledge, stay informed with the latest news, and monitor market analysis.

6. Stay Calm: If you do find yourself in a drawdown, the first and foremost thing is to remain composed. Panicking can lead to hasty decisions that could exacerbate your situation further.

Forex Deposit Drawdown: What It Is and How to Recover from It1

What Should a Trader Do During a Drawdown?

All the six tips mentioned are valid and highly beneficial. However, as stated at the beginning of the article, a drawdown is an inevitable phenomenon in the Forex market, one that every trader will face sooner or later. The key is to be prepared for it and have a clear action plan in place for such scenarios. Let's consider three possible approaches.

1. The simplest method is to close the trade and lock in the loss. This step is indeed straightforward, but psychologically challenging - what if, after I close the position, the price reverses in my favour? Then, I could have made a profit! A substantial one at that! Human greed is a potent force. Overcoming it is aided by a pre-set Stop Loss order. However, experience shows that greed can still triumph here. Some traders, when faced with such a situation, keep moving their Stop Loss further and further away from their entry point. Others don't use these orders at all, preferring to gamble and bank on luck. After all, there's a reason the saying goes, "No risk, no champagne."

2. And so, your position remains open, and the price continues to move against you, increasing the current loss with each passing minute. In such cases, some traders resort to option No.2: they open a position in the opposite direction (not necessarily on the same currency pair), essentially hedging their risks. In professional jargon, this is also referred to as "locking" or a "lock." However, a new challenge arises here. By locking a position in this manner, you merely fixate the current level of loss. No matter how the quotations of the primary and hedging pairs fluctuate afterward, the loss remains constant. To minimize it (or even make a profit), one has to choose the most advantageous moment to close one position and then the other. Yet, accomplishing this is a challenge, even for seasoned traders.

3. Apart from the two aforementioned options, there's also a third method: the Martingale approach and its more advanced version, known as "averaging positions." This method has been employed by hundreds of thousands of traders in millions of different situations. It's incorporated into numerous trading strategies for both manual and automated trading using expert advisor robots. For some, it has led to success, while for others, it has resulted in complete financial ruin. Debates around it have been ongoing for many years. And for that very reason, we will give it special attention.     

Martingale: It's Not a Surname

The Martingale concept in probability theory emerged between 1934-1939. However, the history of this method is much older. Martingale refers to a class of betting strategies that originated in 18th-century France and gained popularity there. The simplest of these strategies was devised for a game where a player wins the bet if a coin lands heads up and loses if it lands tails up. (Similar to betting on black or red in roulette). The strategy involved the player doubling the bet after every loss. So when a win finally occurred, it would offset all previous losses and yield a profit equivalent to the initial bet.

According to the Law of Large Numbers, the probability of a coin landing on heads or tails (or black and red in roulette) approaches 50%. Therefore, given an infinite number of tosses, the Martingale strategy will eventually yield a win for the player. But this assumes that the player has infinite wealth and no limit on the size of a single bet. However, no player possesses such capital, and the exponential growth in bets can bankrupt them.

It's worth noting that one of the longest consecutive streaks in roulette was recorded in 1943 at an American casino, where the colour red came up 32 times in a row. The probability of this is exceedingly small, but it did happen. If a player's initial bet was $1, then the 32nd bet, after constant doubling, would have been a staggering $2.147 billion! And the reward for this would have been just a measly $1.

Trading with Incremental Buying or Averaging Positions

On Forex, the principle of the Martingale method is similar: after each losing trade, the size of the next trade is increased. If the next trade is also a loss, the position size is doubled again, and so on, until a winning trade occurs, which in theory should compensate for all previous losses. Understandably, such a simplistic method often led to financial disasters, hence the need for refinement. One such refinement is trading with position averaging.

Example: Let's say a trader bought a certain asset at 1.2000, expecting it to rise. However, the price began to fall and reached 1.1900. If the trader is confident in their initial analysis and believes the market will soon turn in favour of their position, they can buy another batch of this asset at the current price of 1.1900. This means the average entry price will be 1.1950. To break even on the position, the asset price only needs to reach this level, not the initial 1.2000.

However, trading thought evolves, and over time much more complex versions have emerged, many of which are foundational to algorithmic trading using expert advisors. According to these strategies, new trades open at varying distances from each other, based on technical analysis results, depending on signals from various trend indicators and oscillators, Fibonacci levels, support/resistance level breaches, wave analysis, and so on. Meanwhile, the volume of the subsequent position (lot size) isn't simply doubled but calculated using quite complex formulas. Such algorithms also take into account desired profits, an acceptable degree of risk, and numerous other parameters.

The choice of variants here is endless. But the main principle remains the same: if a trader opens a position and the price moves against them, they open another position (and then another, and another) in the same direction as the first losing position but with a larger volume. This is done so that when the price turns in their favour, they can break even or even make a profit. This is the primary and sole advantage of these strategies. Next, it's essential to list the main risks:

1. If the market continues to move against the trader's position, losses will accelerate due to the increasing volume of open positions.

2. Even a short series of losing trades can lead to a significant drawdown of the deposit. The available margin level decreases, increasing the risk of a forced position closure by the broker when the stop-out level is reached.

3. The emotional and psychological strain on the trader increases as the loss becomes more palpable.

4. One must also consider phenomena like "black swans": sharp and unexpected market movements that can ruin any, even well-thought-out, trading strategies.

This is why experienced traders recommend limiting the number of new positions because the market may not reverse. It's also crucial to calculate risks in advance and be mentally prepared, overcoming oneself, to close losing positions on time. Every step should be the result of well-thought-out decisions. Remember: in trading on financial markets, logical actions lead to success, while impulsive ones are a direct path to losses.

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