Identifying Your Trading Risk Through Intra-Trade Drawdowns
Article Summary: Analyzing your trades after closing the position helps you determine the effectiveness of your Forex strategy. Many traders settle to gauging their success by their account balance. However, strategy effectiveness is not solely about the reward a strategy can produce, but is a function of the risk versus the reward.
As traders, we take risks each and every day through each of our trades. Whether you acknowledge the existence of those risks or not, they are there. Much like gravity, I can choose to believe that gravity doesn’t exist, but when I walk off roof of a three story building, I’ll painfully be reminded that gravity does exist.
The same applies for risk in the markets. Newer traders generally take the view of the market from the perspective of how much they have to gain in a particular trade or perhaps they expect to double their account in a month without an understanding of the risks it takes to perform at those levels.
Experienced traders know that losses and drawdowns are a part of trading. Therefore, experienced traders will look for performance measures to gauge their strategy’s signal and exposure efficiency. Essentially, experienced traders want to know whether their strategy is efficiently entering and exiting out of the market.
Additionally, is too much risk is being shouldered while in an open position? One such measure I would like to introduce today is the idea of intra-trade drawdowns which can help us identify the risk taken and efficiency of our entries.
Before we discuss how to use intra-trade drawdowns to adjust our strategy, let’s first review what exactly it is. You may hear intra-trade drawdown referred to as a maximum adverse excursion. It simply represents how far your open position floated as an open losing trade. Said another way, how far did this open trade wander against your entry price?
Here are a couple examples.
Assume that you entered into a EURUSD trade as a buyer at 1.3100. An intra-trade drawdown would be the exposure in your trade below your entry price. So if your open position falls to 1.3050, your trade would have experienced a 50 pip drawdown.
In another trade, assume you buy the AUDJPY at 85.00. At one point, while this trade is open, if the price falls to a low of 84.25, then this trade would have a 75 pip intra-trade drawdown.
In both of the examples above, simply noting and averaging out your intra-trade drawdowns, doesn’t really tell you anything. We need to take those figures and compare them against the profit targets and winning trades to provide any insightful analysis.
Average Intra-trade Drawdown versus Average Profitable Trade
At DailyFX EDU, we talk constantly about using a positive risk to reward ratio. In fact, DailyFX conducted Traits of Successful Traders research and identified the biggest reason traders lose money in their accounts is because they risk a lot to make a little.
By identifying our average maximum adverse excursion, we can see how much we have actually risked on the trades and how disciplined we followed our Forex trading plan.
For example, let’s say a trader identifies their average intra-trade drawdown to be -30 pips. However, even though they have a target of 50 pips, they end up closing trades down for an average of +20 pips. In this example, their risk is greater than their reward. As discussed in our Traits of Successful Traders Research, we want to risk less than our average reward or try to risk a little to make a lot.
If you find your post-trade analysis providing a relatively low intra-trade drawdown, then congratulations! You are efficient at finding entries into the market. What is relatively low? I would suggest you are efficient at finding entries when you close out your trades consistently at twice (or greater) the distance of your maximum adverse excursion.
---Written by Jeremy Wagner, Head Trading Instructor, DailyFX Education
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