When a trader starts trading, especially with prop firms, they’ll come across many new rules and terms. One term that might confuse them at first is “drawdown.” A drawdown is basically the drop in trading account from its highest point after the trader had made some losses. Understanding the different types of drawdowns is important because it helps the trader manage their risk and protect your trading account. In this article, we’ll explain the four main types of drawdowns: Balance-Based, Equity-Based, Static, and Trailing Drawdowns.

What Is a Drawdown?

Before we dive into the details, let’s make sure we understand what a drawdown is. A drawdown is the amount your trading account decreases after a series of losses. For example, if your account grows to $10,000 and then drops to $9,000, your drawdown is $1,000. Knowing about drawdowns helps you understand how much risk you’re taking and how much you can afford to lose.

Why Understanding Drawdowns Is Important

Understanding drawdowns isn’t just about knowing how much you can lose; it’s about knowing how to manage your risk and protect your account. If you don’t understand drawdowns, you might end up losing more than you can handle, especially when trading with borrowed money or within the strict rules of prop firms.

1. Balance-Based Drawdown

What Is Balance-Based Drawdown?

Balance-Based Drawdown is linked to your account balance. It changes whenever your account balance increases, so it adjusts as you make profits.

How Does It Work?

For example, if you have a $100,000 account and a 10% drawdown limit, your maximum drawdown is $10,000. If you grow your account to $120,000, the 10% drawdown limit becomes $12,000. If your account drops to $90,000, your drawdown limit stays at $90,000.

Why Is It Important?

This type of drawdown is important because it adjusts as your account grows, allowing you to take on more risk when you’re doing well. But it also means you need to pay close attention to your balance.

2. Equity-Based Drawdown

What Is Equity-Based Drawdown?

Equity-Based Drawdown is based on your account’s equity, which includes both your balance and any open trades. It adjusts in real-time, so it’s constantly recalculating even if your trades are still open.

How Does It Work?

For instance, if your equity peaks at $10,000 and your drawdown limit is 10%, you can afford to lose $1,000. If your equity falls to $9,000, you’re still safe. But if it drops to $8,900, you’ve hit your drawdown limit.

Why Is It Important?

This type of drawdown is important for active traders who need to keep a close eye on their risk. It’s a bit stricter because it can limit your losses even if you haven’t closed a trade yet.

3. Static Drawdown

What Is Static Drawdown?

Static Drawdown is the simplest type of drawdown. It’s a fixed percentage of your account size and doesn’t change, no matter if you’re making money or losing it.

How Does It Work?

For example, if you start with $100,000 and have a 10% drawdown limit, your maximum loss is $10,000. The drawdown is only triggered if your balance drops to $90,000, and this limit doesn’t change no matter how your account performs.

Why Is It Important?

Static Drawdowns are easy to understand and manage, making them great for beginners. However, they can be a bit limiting since they don’t adjust based on how well you’re doing.

4. Trailing Drawdown

What Is Trailing Drawdown?

Trailing Drawdown follows your account’s highest equity point as it grows but doesn’t drop when your equity decreases. Some traders find this type of drawdown frustrating because it locks in your gains but doesn’t give you much room to recover from losses.

How Does It Work?

For example, if your equity goes from $10,000 to $15,000, the trailing drawdown might be set at $13,500. If your equity then drops to $14,000, your drawdown limit stays at $13,500, not $12,600. It only moves up, not down.

Why Is It Important?

Trailing Drawdowns are great for protecting profits, but they can be tough to manage because they lock in your highest equity, making it harder to bounce back from losses.

Choosing the Right Drawdown for Your Trading Style

The best drawdown type for you depends on how you trade and how much risk you’re comfortable with. If you like to play it safe, Static or Balance-Based Drawdowns might be a good fit. If you’re more aggressive, you might prefer Trailing or Equity-Based Drawdowns, but these require more discipline.

Conclusion

Knowing about the different types of drawdowns is crucial for anyone getting into trading, especially in the prop firm space. Each type—Balance-Based, Equity-Based, Static, and Trailing—has its pros and cons. Choosing the right one depends on your trading style and how much risk you’re willing to take. Understanding these drawdowns will help you manage your risk better and improve your chances of success in trading.