When it comes to buying Forex Prop Firm Challenge Accounts, taking consideration on what kind of drawdown does the prop firm is providing is really really important. Prop firms do provide a large amount of capital to traders for a small amount of price but while they actually do provide capital, they do not appreciate that anyone should just burn their money and is very unprofessional with their given capital. 

This is why Prop Firms add Drawdowns in their challenge accounts which adds the limit on how much a trader can lose in their account in daily basis and overall basis. These drawdown come in different types and two of the most commonly used Drawdowns are Balance-Based Drawdown and Equity-Based Drawdown. 

What is Balance-Based Drawdown and How Does It Work?

Balance based Drawdown is kind of Drawdown which increases as the account grows but never decreases if the account makes a losing trade. 

How Does Balance-Based Drawdown Calculate?

Balance-Based Drawdown or Balance-Based DD is calculated based on the highest balance of the account has achieved. As the account grows with the profit, The Drawdown or DD Limit will increase and adjust based on that. 
This helps the trader in trading when there is about to be a loss but because of the balance based drawdown and increased drawdown limit can let the drawdown hold their trade instead of hitting a daily or overall loss. There is also one extra crucial factor that this kind of drawdown stays stable until a profit or loss has been booked.

Example of Balance-Based Drawdown

Let us demonstrate it with an example :

• Account Size: $10,000
• Drawdown Limit: 5% of the balance, which is $500. 

When a Trader Makes Profit :-

If the trader makes a $2,000 profit and his/her account balance increases to $12,000, the drawdown limit will also increase and Now, the new Drawdown limit will be 5% of $12,000, which is $600. This means a trader can now take advantage of an extra $100 if they ever hit a loss. 

When A Trader Makes Loss :-

If the trader makes a losing trade and loses $100 and the balance drops to $9,900 from the starting balance of $10,000. The drawdown limit doesn’t change because it’s based on the highest balance that account has reached. The drawdown limit remains at 5% of $10,000, or $500 and will not be calculated based on $9,900. 

What is Equity-Based Drawdown and How Does It Work? 

Equity-Based Drawdown is a bit tricky and complicated. It can grow or shrink based on the real-time market conditions, this means that the drawdown will never stay stable as long as the trader is not trading but if the trader has an open trade then the drawdown limit will keep changing every moment based on the direction of trade and where the trade is progressing towards.

Example of Equity-Based Drawdown

Here’s how it works:

• Account Size: $10,000
• Drawdown Limit: 5% of the equity, which is $500. 

When A Trader Makes Profit

If the trade is going well and the account is making a profit of $2,000, the equity will now be $12,000 and The drawdown limit will adjust to 5% of the amount, which is $600. However, the limit will keep changing based on the performance of the trade.

When You Have a Loss

If the trade is making loss and the equity is dropping to $9000 then the effect of the drawdown will start reflecting on the drawdown limit as it will shrink to 5% of the $9000 or $450. If the equity goes below $8,000 then the limit will be dropped to $400 and so on. The drawdown will keep growing or shrinking as the trade progress. 

Why Balance-Based Drawdown is the Better Choice?

1. Stability in Unstable Markets

Balance-Based Drawdown is more stable and helps a lot in volatile markets like gold and crypto. As it is calculated based on the highest balance an account size has reached, it provides extra help even if the market fluctuate which will give a more predictable and calculated risk management. 

2. Encourages Account Growth

With Balance-Based Drawdown, The Drawdown limit increases as the account grows, therefore it also encourage traders to build as big of a drawdown limit as they can to trade with bigger account size and make their trades risk free. 

3. Easier Risk Management

Balance-Based Drawdown does not change every second as the market moves therefore it becomes much easier to manage risk as now the trader can set their Stop-Loss(SL) and Take Profit(TP) more precisely and can stay relieved that their drawdown limit will not decrease if the trade goes toward a loss. 

4. More Flexibility

There are often times that the market moves in the exact direction as the trader predicts but due to smaller stop loss and small drawdown limit, the room for taking bigger risk are very narrow but as the account grows, the trader gets this advantage to take bigger risk after their account has grown. 

5. Less Stress

Trading is a very stressful activity but with Balance-Based Drawdown and a calculated approach, trader can stay relieved that their drawdown limit will not decrease if the trade goes bad as even if they book a losing trade, they will still have the same drawdown limit.

The Downsides of Equity-Based Drawdown

1. Constant Changes

One of the biggest downside of Equity-Based Drawdown is that it is constantly changing which makes it really hard for risk management and when trading with volatile market the equity based drawdown can make the trades stay in profit really hard.

2. Higher Stress Levels

As Equity-Based Drawdown is unstable and can grow or shrink based on the trade, it makes the trading very stressful as even one losing trade can make the drawdown limit shorter which will lead the trader to add tighter stop loss forcefully.. 

3. Not Ideal for Volatile Markets

As we have mentioned already, Equity-Based Drawdown is just not that suitable for volatile markets. Instruments like XAUUSD , BTCUSD or US30 , they are hyperactive most of the time the trade might look going in loss and in next few minutes it can go in profit but a higher equity loss can lead to drawdown being hit.

4. Limited Room for Growth

Equity-Based Drawdown is good only when a trader is in profit, once a trade goes in loss and equity drops below the initial balance, it becomes harder to recover due to smaller stop loss and it can lead to a downward spiral. 

Conclusion

These are few key points and explanation on how these industry leading drawdown works and due to these reasons we recommend that Balance-Based Drawdown is often a better choice than Equity-Based Drawdown as it is more stable and predictable which makes risk management very easy. On the other hand equity based drawdown with it constant changing nature can limit the trader’s potential and make trading more risky and stressful for the trader.