A drawdown in trading is the difference between the highest account balance and the balance after a pullback or a streak of losing trades. Drawdowns often occur when a trader experiences a series of consecutive losing trades.
Stock prop firms realise that these streaks exist, no matter how good your strategy is. Therefore, they have put in place rules and limits to ensure their capital is protected from deep drawdowns. These limits help traders manage their risk better, but can also add pressure to perform.
DAILY DRAWDOWN
The first type of risk management tool is the daily drawdown. Most stock prop firms set a percentage loss limit for their funded traders. In this case, the limit applies to a single trading day. If you exceed the limit, you will violate the trading rules and likely have your account suspended or closed.
FTMO daily drawdown
An example of a daily drawdown is the one set on FTMO. For each account, the trader gets a daily drawdown of 5%. For instance, a $10,000 account has a drawdown limit of $500. Therefore, traders cannot lose more than $500 in a single day.
OVERALL DRAWDOWN
Prop firms also have an overall drawdown. This kind of drawdown applies to your overall trading activities. Therefore, there is no time limit. Traders must always ensure that no losing streak exceeds their overall drawdown limit.
FTMO overall drawdown
On FTMO, the overall drawdown is set at 10%. Therefore, for the same $10,000 account, traders cannot lose more than $1,000. As a funded trader, you must fit your risk management strategy into a prop firm’s drawdown limits. These limits should determine the size of your trades.
FITTING YOUR STRATEGY INTO DRAWDOWN LIMITS
To fit your trading strategy into a drawdown limit, you must know what kind of losing streaks you can experience. This means backtesting the strategy. Take note of all losing streaks and record the number of consecutive losses. If your strategy’s biggest losing streak has 15 losses, then you have to give yourself enough room for such an outcome. In this case, you can push it up to 20 or 30 trades depending on your preference.
Therefore, if you have room to lose 20 trades and you have an overall drawdown of 10%, you cannot risk more than 0.5% per trade. This will ensure that if you experience a losing streak, you can recover without violating the drawdown limits.
At the same time, if you are risking 0.5% per trade, you can put a cap of 5 or 6 trades per day to ensure that if you have a losing streak, you do not get near the daily drawdown.
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IMPORTANCE OF DRAWDOWN LIMITS
Drawdown limits are crucial for several reasons when trading.
RISK MANAGEMENT
The most important is risk management. Prop firms prevent traders from losing too much money by setting loss limits. At the same time, traders learn to manage their own risk and avoid making significant losses that can affect their trading confidence.
PROFIT PROTECTION
While trading, you will realise that it is easier to lose than to make money. It can take such a long time to grow your account. However, when losses come, they bring emotions that can quickly wipe out all your profits.
Drawdown limits ensure that you are always conscious of protecting your profits. When you start losing, it is easier to pause when you have a drawdown limit. Without it, you can continue trading until you lose all your profits and capital.
DISCIPLINED TRADING
Drawdown limits instil discipline in traders. When you have a daily loss limit, you will strive to only focus on quality trades. This is different from a trader without such a limit. Here, you can have days when you are overtrading because of greed. If all these trades end up losing, you will cause significant damage to the account.
HOW STOCK PROP FIRMS APPLY DRAWDOWN LIMITS
Stock prop firms use drawdown limits mainly to protect their capital. It is difficult to know whether every trader they get is skilled enough to protect the funds they trade. Therefore, the loss limits level the playing field and ensure the firms do not experience catastrophic losses.
Moreover, it is a good way to filter traders. A trader who respects the limits and consistently grows an account will benefit the firm. On the other hand, a trader who keeps violating loss limits might not have much experience and would be a liability to the firm.
OTHER TYPES OF DRAWDOWN LIMITS
Other types of drawdown limits include the trailing drawdown.
TRAILING DRAWDOWN
Unlike a fixed drawdown, the trailing drawdown changes as your account grows. Essentially, the trailing drawdown increases in line with your account balance, continuing to protect your profits as the account grows.
Therefore, if you have a balance of $10,000 and a trailing drawdown of 10%, your initial limit is at $9,000. However, if your account grows to $11,000, your drawdown climbs to $10,000. However, this type of drawdown may put more pressure on traders to perform, which may not be sustainable in the long run.
STOCK PROP FIRMS WITH LENIENT DRAWDOWN RULES
A lenient drawdown rule allows a trader to grow and gain more room for losses. Therefore, the most lenient is a drawdown based on the initial balance. Some prop firms apply drawdowns on a trader’s equity. This means the drawdown keeps changing. However, teh room for losses remains the same.
TradeThePool drawdown limits
Some stock prop firms that offer a drawdown based on the initial balance include FTMO and TradeThePool. With these firms, you will have sufficient room to grow, which will ease the pressure of an ever-nearing drawdown limit.
Join FTMO or TradeThePool today and start working on a challenge. Become a funded trader with the top prop firms in the industry.
