Prop Trader Confidential: Avoid This Pitfall
There are various reasons why most prop traders fail, including inexperience, a lack of discipline, over leverage, poor risk management, lack of a trading plan, poor trading skills, inability to adapt to changing market conditions just to name a few.
However, there is one rule that tilts the odds in favor of the prop firms and puts the trader at a disadvantage. It is called relative drawdowns.
As noted in 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.
Relative drawdown vs. absolute drawdown
Relative Drawdown
A relative drawdown is a percentage that measures the decrease in a trading account’s balance from its highest point to its lowest point. It’s calculated by dividing the difference between the equity at the peak and the equity at the trough by the equity peak
Absolute Drawdown
Absolute drawdown is a measure of the maximum amount of capital that could be lost in a trading account. It’s calculated by subtracting the lowest point of equity from the highest point within a given period
(AI Overview)
Let’ say you are taking a prop firm evaluation test with a 5% relative drawdown and a 10% profit target. This doe not mean you can lose up to 5% from your initial deposit and stay in the game. It means you cannot lose more than 5% from your high water mark.
Example: $100K Prop evaluation test, 5% drawdown
Initial deposit: $100,000
5% initial drawdown $95,000
Highest account balance $104,000 ($4000 profit)
Maximum (relative) drawdown $98,800 ($104,000 x .95 or .05 x $104,000 = $5.200)
Trader loses $4000 and account balance is back to $100,000… profit target is still 10% of initial deposit (i.e. $110,000)… BUT drawdown limit is only $1200 (not the initial $5000).
So, if the trader loses $1200, he/she would be in breach and fail the test.
Be aware of your relative drawdown
You can see why the relative drawdown works in favor of the prop firm and a trader not only has to be aware of it but also actively manage the account to avoid breaching the rule.
So, if you are looking to take a prop trading evaluation, be aware of what a relative drawdown means and monitor you account balance. As noted above, a trader can be profitable but still breach the relative drawdown rule and fail the evaluation.
Prop Trader Confidential: Avoid This Pitfall
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