The Lowdown on Drawdown


Because i'm forever being dq'd from the demo contests at forex razor (given their focus on account equity) because I keep exceeding drawdown limit, I am posting this to myself, really, because then it has to be clear to me - and hopefully some of you - what it is i'm on about ...

Right: Most systems today, including MT, express drawdown only in terms of closed trades, so if the trade goes into a huge loss but is never closed and eventually recovers and is closed at a profit, the drawdown is hidden and never expressed - this is referred to as 'balance drawdown' or 'closed trades drawdown'.

The opposite of 'closed trades dawdown' is 'equity drawdown', where unrealized losses (and gains or draw-ups) occur regardless of whether a position is closed or open; that is, everything that happens between the opening and closing of the position is recorded and unrealized losses are recorded as drawdown. You get penalized for failing to maximise your potential win.

For example, these demo contest parameters:
  1. Participants who meet or exceed 25% equity drawdown will be disqualified. Drawdown is calculated based on peak-to-valley equity, thus new account highs will impact drawdown tolerance
  2. Leverage set to 1:125, with margin stop outs set to 100% of required margin
  3. Maximum lot size per trade is set to 2.5. Opening simulated balance is $2500

So far, so ho hum.

Lets say i open up 1 lot buy position and it goes my way right away. I have now a floating positive pip amount of 1000 pts. equity at 3500. Now i'm going to set my stop loss to plus 5 pts to get breakeven including the commission. Now i turn off computer. Question is after 24 hours my breakeven stop loss is hit from equity high of 3500, its now back to 2500 starting balance.

Will i be disqualified if that's the case? A big fat 'YES'.

A simple calculation is to work out 25% of my account equity high position:
$3500 * 25% = $875

Now dropping account equity by this amount from account equity high will hit the 25% DD limit and 1 cent over will exceed the limit.
$3500 - $875 = $2625 (This is my equity threshold for 25% DD limit from equity high position).

Using the values that I have stated above: $1000 profit (Equity High $3500) = 40% gain from opening equity of $2500
New account equity low position after account equity high is $2500 = 0% gain from opening equity of $2500

DD formula is: 100 * (High – Low) / (High + 100)

And that looks like this: 100 x (40 - 0 / 40 + 100) = 28.5714 and some more numbers after that, like a Las Vegas limousine (only without the bright lights and the come-all-ye casinos, and the losing streak...)
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Sounds like they need to reexamine the rules so that floating and closed drawdowns are penalized more equally. Still, I'm impressed to see any contest that at least tries to address drawdown. Most contests focus only on the final results, no matter what risks were taken.