Prop Trading and the Dreaded “Relative Drawdown”
One of the biggest reasons traders fail prop firm evaluations is not understanding how relative drawdowns and high-water marks work. They don’t realize they could be a profitable trader and still breach the relative drawdown rule. Losing trades cause drawdowns and as such can’t be actively managed.
You’re either making money or losing money. Relative drawdowns on the other hand can and must be actively managed otherwise even a profitable account can breach the relative drawdown rule.
Let’s start by defining the difference between account balance and account equity.
Account balance is starting balance plus/minus profits/losses on closed trades. Account equity is account balance plus/minus profits/losses on open positions. Account balance is what determines your high-water mark, and your relative drawdown always starts from this number.
Suppose you have a $100K account and you have 2 trades running. One trade is up $2500, and the other trade is down $1500 so the account is profitable by $1k.
Now you want to close both trades. If you close the winner first the high-water mark jumps to $102500 but when you close the loser the account balance not only drops to $101,000 but you’re now in a $1500 relative drawdown! So, you end up doing 2 trades, making money, yet find yourself in a $1500 relative drawdown!
Keep trading “profitably” this way and you’ll breach your account in no time! Instead, if you sold the loser first the account balance temporarily drops to $98500 but then the winner brings you back to $101,000 and now not only is the account profitable but you’re at a new high-water mark with no relative drawdown. That’s a huge difference.
It is imperative to carefully consider this before closing any open trades.
Now suppose you don’t want to close both trades. That’s no issue if you want to sell the loser and hold on to the winner as you’re not increasing the high-water mark.
It’s a different story if you want to sell the winner and hold onto the loser as you will increase the high-water mark and immediately put yourself into a big relative drawdown. It’s very easy to avoid this situation.
Close both trades by closing the loser first and then the winner and then put the losing trade back on. It might cost you a small commission and spread but you solved the relative drawdown dilemma.
Clearly if you only run one trade at a time this isn’t a concern however if you run multiple trades at a time, like I do, managing your relative drawdown is a critical part of any trading decision you make.
We’ve all heard the adage “Cut your losses short and let your winners run”.
For a variety of reasons I will explore deeper in a future post, suffice it to say that a very typical trait of most traders is they tend to do the opposite, take profits too soon and let losses run. When you combine this
tendency with a failure to properly manage relative drawdowns it becomes much easier to understand while a very high percentage of traders fail their prop firm evaluations.
For more information feel free to contact me by email at michael@theamazingtrader.com.
Michael Weissman
Prop Trading and the Dreaded “Relative Drawdown”
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