Calculating your trailing drawdown is crucial to developing a successful trading drawdown strategy. Much like a stop-loss limit, it allows traders (and those funding the account) to limit their financial exposure. A trailing drawdown limit will only move higher (to a limit) as the size and value of your account increases, thereby continuously protecting your capital. In many cases it calculates both open and closed equity. There are several factors to consider when it comes to calculating it, which can offer a degree of flexibility to traders.
The best way to describe a trailing drawdown is to give an example of our trading evaluation, The Gauntlet Mini™. It offers participants the opportunity to show their intraday trading skills and secure a third-party funded proprietary trading account. It is essential to work under the same conditions as “live” intraday traders, mimicking where possible the same pressures. One of these challenges is the trailing drawdown, which is especially important in the early days.
As you can see from the following table, each virtual account available for the Gauntlet Mini™ has a different starting balance. There is also a different trailing drawdown per account, which relates to the initial virtual capital figure. For example, if you run the Gauntlet Mini™ $25,000 challenge, your maximum drawdown will start at $23,500. If your account falls to this level, your virtual positions would automatically be liquidated and the trading account closed. In simple terms, a trailing drawdown is a level at which your capital, virtual or real, is effectively protected.
Some trailing drawdown calculations are based on a percentage of the starting capital, while others, as above, are quoted in dollars. A trailing drawdown for the $25,000 account is 6% in the above example, although this falls to 3% for the $150,000 account. However, the real value of a trailing drawdown shines brightest when your open and closed positions begin to show a profit.
So, we know how the initial trailing drawdown is calculated depending on your starting capital. Now, as you begin trading, this is where the fun begins!
Breaking Down the Trailing Drawdown in Detail
In this instance, we are not taking into account intraday highs, including open and closed positions, but we will cover that later. The above table shows how a trailing drawdown will work in practice, taking into account trading profits and losses. As you can see, before trade number one, the account balance is $25,000. This equates to a trailing drawdown of $23,500 (starting account balance less than $1,500). It is important to note that a trailing drawdown will always move up, and it will never move down.
After the first trade, the account balance has increased by $500 to $25,500. The trailing drawdown balance also increases by $500 up to $24,000. The second trade is profitable, increasing the account balance to $26,000, and a trailing drawdown increases to $24,500. The third trade makes $1,000, which increases the balance to $27,000, but the trailing drawdown only increases by $500 to $25,000. While a trailing balance will never decrease, it will never increase to more than the initial starting balance, in this instance, $25,000. We have also added some trading losses into the table to show how a trailing drawdown does not fall.
If we look further down the table, we see that the account balance fell to $25,000 after the eighth trade. This was the same balance as a trailing drawdown at the time. Therefore all positions would have been liquidated and the account closed. On the flip side, if you were to instantly make a $20,000 profit, taking your account balance to $45,000, a trailing drawdown would only increase by $1,500 up to $25,000 (this is the maximum level). So, in theory, you would have $20,000 of trading headroom between your account balance and a trailing drawdown.
Intraday and Closing Account Balances
The use of intraday valuations is another deterrent for those tempted to take potentially high risk/volatile positions. If, for example, you had a $25,000 account balance and a $23,500 trailing drawdown, this would leave scope for volatility just less than $1,500. When a volatile asset takes the account balance, intraday, up to $27,000, it will prompt a recalculation of a trailing balance up to the maximum $25,000. If there was a bout of profit-taking and the account balance fell to $25,000, all positions would be liquidated and the account closed. Even though the start and end day balances were the same, the intraday volatility prompted drastic action.
How to Avoid Breaking a Trailing Drawdown
It is important to appreciate a trailing drawdown prior to trading and build your investment strategy around it. You will find that virtual and proprietary trading accounts will have levels of maximum exposure per trade to discourage high-risk trades. The following two tables give you an idea of how your account balance could be impacted with a maximum 2% risk per trade against a maximum 10% risk per trade.
2% Risk Per Trade
10% Risk Per Trade
If you look at the account balance, to the left of the 2% risk per trade calculation, you will see that the initial trading loss is $500. As the account balance reduces, the loss per trade also falls, and it is not until after trade number three that the account balance falls to anywhere near the $23,500 trailing drawdown. Remember, this is the initial trailing drawdown calculation on the starting balance. As the account balance has continuously fallen from day one, the figure remains static as it can only increase.
We will now focus on the account balance to the left of the 10% risk per trade calculation. Since the trading loss is larger, the $23,500 trailing drawdown limit would have been hit intraday with the first trade. As a consequence, all positions would have been liquidated, and the account closed. Diversification is critical!
Why is This Rule Important?
A trailing drawdown is a means of protecting capital, especially in the early days, when it may be tempting to take undue risks. The following table perfectly illustrates the impact of a range of capital losses and the appreciation required to get back to breakeven.
Loss of Capital
% Required to Get Back to Breakeven
In this instance, we will assume that there was no trailing drawdown trigger. If you saw a 50% reduction in your trading account balance from $25,000, you would be left with just $12,500. So while the fall was 50%, to return back to breakeven, your account balance would need to double, i.e., increase by 100%. If your account balance fell by 90%, it would need to increase by 900% to return to breakeven. This perfectly illustrates the significant role that trailing drawdown triggers have with trading accounts.
Do I Have to Follow a Trailing Drawdown After Getting Funded?
The whole point of futures trading programs, such as the Gauntlet Mini™, is to create a realistic environment for those looking to secure a proprietary trading account. Therefore, it is important to maintain this discipline when trading with “real funds” and refrain from overdue risk and heavy exposure to individual futures contracts. If we strip away the emotion, the figures, and futures trading comments, it is simple.
Cut your losers and run your winners
Never let your ego lead you down the wrong path. Even the best and most experienced investors sometimes get it wrong!
The best way to describe a trailing drawdown is a type of stop-loss limit which will protect your initial virtual/real account balance. Whether virtual trading or using a proprietary trading account, there will be limits to the maximum risk exposure allowed per trade. Reducing your downside and potential for a liquidation trigger leaves you greater scope to bank long-term profits.