Drawdown: The Hard Truth For Every Trader
Incurring drawdown in a trader’s journey is inevitable. But hardly anyone understands how likely it is to occur. Everyone seems to assume that they will not incur a drawdown in their trading, or at least do not know how to handle it when they do. In this report, I will be breaking down the likelihood of a drawdown for a variety of different win-ratios and risk-to-rewards. This will be compared with funded challenges and how they can set you up to fail without even being aware.
For the purpose of this report, I will be using a mathematical approach, taking a variety of different win-ratios and risk-to-rewards into account. This will be done using a risk-of-ruin calculator. There are plenty of these calculators available online and a valuable resource for every trader.
What is a risk-of-ruin calculator?
What a risk-of-ruin calculator indicates to us is the probability of a specific drawdown amount occurring, as well as the risk of completely blowing an account, over a specific number of outcomes. This is useful as we can compare multiple different strategies to understand expected loss levels.
Here is a screenshot of a risk-of-ruin calculator:
The way it works is by simulating the data input into a number of scenarios to give the percentage probability of occurring.
This is important as we can consider what is to be expected when trading a particular strategy and also expose paid funded challenges.
Examples
Let’s say you have a profitable trading strategy with a 40% win-ratio % and 2:1 risk-to-reward, you would have around a 40% chance of incurring a 10% drawdown and a 10% of blowing your account. See the figure below:
Now many of you may view this and think that your system may be better than this. If you do, then congratulations. The truth, however, is that these stats are among the top 5% of traders. A consistently profitable trading system is extremely rare in the industry. These stats are very much achievable but are also able to give consistent returns. A funded trader, such as one of Samuel & Co, would be able to generate an additional income, making regular withdrawals with these stats.
What is even more interesting is that the more you increase the number of trades, the more certain of drawdown you will be. So if we change the 100 trades to 1000, the probability of hitting the 10% drawdown jumps to 99.8%. Therefore the more you trade an account, the more likely you are to incur a large drawdown.
Many traders are unaware of something like this that is so important to their trading journey. This consistently profitable system may start to get into a drawdown and panic. They may believe that they are profitable and therefore, should not incur a drawdown. But the truth is, using a mathematical approach, we can see that it is almost inevitable. There is also a high chance (12.5%), that even with how profitable they may be, they could blow the account.
This is due to the random clusters of wins and losses. The calculator is simulating the number of trades to indicate the probability where you end up in a 10% drawdown or worse; blow the account.
But what if you increase your risk-to-reward?
You are still left with an extremely high probability of incurring a 10% drawdown.
If we change the win ratio to 50%, putting this trader as one of the best traders in the world:
The probability is still 30%. For the record, anything above a 50% win ratio is phenomenal in the industry. It is often said that even professional, institutional traders would cut off one of their arms for a 50% win ratio.
If you were to tell most traders if they had a 50% win-ratio with a 3:1 risk to reward that they had a 30% probability of hitting a 10% drawdown, they would not believe it. Or even if they did believe you, they would still not know how to handle actually being in that situation.
Funded Accounts
This is crucial when we consider that the majority of funded accounts only allow for a 10% drawdown. When you look at the most popular paid funded account challenges, they all have a 10% drawdown limit. This means that even if you pass all of the stages to the challenge and get offered a funded account, you still are putting yourself in a position of almost certain failure.
In a previous report, I went through the data of these challenges and broke down the figures to show how few people pass these challenges and how even fewer kept accounts.
For this particular company, one of the largest in the space, only 5 traders were on their 8 consecutive payouts. To put this in perspective, around 5000 people a month were taking the challenge - with the numbers likely increasing far beyond this since. This is the 0.1% of traders, meaning that 99.9% of traders end up failing the challenge. And this is one of the reasons why. These companies create mathematical models designed against naive traders, and this is one of the ways they sway the odds in their favour.
As mentioned in the report, the majority of their revenue comes from failed challenges, meaning by definition, that they have a conflict of interest against you. They know that no matter how good of a trader you may be, you are almost certain to incur a 10% drawdown at some stage.
You could pass the challenge easily, earn a profit, and withdraw, which for your reference is in the top < 0.1-1% of traders, but eventually, you will incur a drawdown and lose the account. This is even for highly profitable traders, as proven in the examples.
I would go out and state that the majority of traders who have one of these paid funded challenge accounts are not sticking to 1% risk. According to the stats, 60% of traders do not even use a stop-loss!
If we calculate just a 2% risk percentage over 100 trades, a highly probable situation for a profitable trader, the drawdown moves to just under 96%. What is crazy is that there is a ⅓ chance of blowing the whole account!
Remember that all of these stats are for consistently profitable traders. Can you imagine the stats for unprofitable ones?
For the 40% win ratio, regardless of whether that trader has a 2:1 RR or a 3:1 RR, they have anywhere between a 90-99% chance of incurring a 10% drawdown. Now that you know this, does this make you think differently about these paid-funded challenges?
Leverage
Remember that most of these paid-funded challenges offer 1:100 leverage. Again there is a reason for this. They know that if traders have the ability to over-risk, they will.
If the risk-of-ruin calculators show us an extremely high probability of failure with 1% risk, what do you think that increasing your risk will do?
It will tip the odds even more so against the trader. These companies know this, hence why they offer it. I refer back to an SEC official publication showing how capping leverage leads to more profitability for retail traders.
https://www.sec.gov/comments/s7-30-11/s73011-10.pdf
“After the US and Japan instituted leverage limits, loss rates of retail FX clients declined. In the absence of entirely banning the product, regulators should reduce leverage to levels consistent with equities of 2x assets/equity. This will further reduce losses experienced by retail FX clients..”
Leverage is a tool that traders can use to place larger position sizes on a smaller account. It is offered to allow retail traders to participate in the marketplace. Remember that institutions keep to low leverage - it is only retail that demands high leverage.
Now yes, some traders may have great risk management and would stick to their rules, but the majority do not. As the SEC report showed, if a trader has the option to, they probably will. There is a greater probability that they risk more on the account, consequently a greater probability that they hit the 10% drawdown.
A common misconception that I see all the time is that traders need leverage to make money. It is completely delusional. In fact, it is the exact opposite.
Firstly, it tends to be losing traders that complain about low leverage. What they do not understand is that you take one side of the market with every trade. If you had traded in the exact opposite way you would have made that amount of money. Therefore, if you can lose money using lower leverage, you could have made exactly that amount. Your thousands of dollars in losses could have been thousands of dollars in profits.
We see it first hand at Samuel & Co Trading. We cap our leverage to 1:3. This promotes not just a consistent risk management procedure but also high-quality trade ideas. If you cannot have many trades open at one time, you have to decide which are the most likely. Therefore, profitability actually increases, which we see all the time with our traders. Traders cannot risk more than 1% without facing consequences, promoting an institutional trading approach. This is why we have so many consistently profitable traders.
If you maintain low leverage, stick to risk management, applying a consistently profitable strategy over and over, you lower the risks of incurring a high drawdown on the account.
What happens in a drawdown?
Now you may say that a drawdown is not a big deal. And if you know what you are doing it is not, (apart from the fact that you could lose a funded account).
The reason we want to avoid a drawdown is due to the effect on our mindset. Many times, a trader who has not hit trading consistency will change the way they trade. If this continues they may never reach profitability.
From my own experience, being able to incur a drawdown and come out the other side is essential to your trading journey. Now, if I go through a drawdown and I feel indifferent to the outcome. I know that I am able to recover any losses and more.
If I was to trade on high leverage and have my funded account taken away from me due to breaking the drawdown limit, do you think I would be able to say that?
30% Drawdown
The alternative solution is having a greater drawdown limit. At Samuel & Co Trading, we have a 30% drawdown limit. This is the maximum risk we are prepared to take, whilst maintaining a 1% risk management procedure.
If we compare the calculations for a 30% drawdown when compared to a 10% one, you can see a significant difference:
The difference between 90-99% and just under 3% is so significant, no wonder that Samuel & Co Traders stay with us for many years. Our traders can look at these stats and then trade with ease, knowing that they can focus on high-quality trading - as a pose to avoid losing an account.
This may seem like a minor difference, but as we all know, fear-based decision-making never ends well for traders. We must focus on trading high-quality setups, allowing probability to play out over the long run.
Conclusion
To conclude, we can use a risk-of-ruin calculator to further understand the mathematics behind our trading. In one of my previous reports, we went through the numbers of paid-funded challenges and how the overwhelming majority fail the challenge. In this report, I have gone through one of the main contributors behind this and how these companies tip the odds against you without you even realising. Stacking a high probability of failure with high leverage of 1:100 seals the deal for naive traders who think that they can go through their trading journey without hitting the drawdown limit.
A trader very may go on to make money from these 10 % drawdowns paid-funded challenges - I am not saying you cannot. I am merely showing you that the data indicates that it is not sustainable over the long term. Many of the people that tend to post results over their social media tend to disappear a few months after. This is most likely the reason why. The odds are against you even as a consistently profitable trader. Do you want 98% odds against you, or 98% odds in your favour with a 1:3 leverage account and a 30% drawdown?
No matter how profitable your system may be, even the best of the best will experience this. The data shows that reducing leverage, following a consistent risk management procedure and allowing a wide enough tolerance, such as a 30% drawdown limit is the most effective way to generate consistent profits. This is proven by the number of traders at Samuel & Co Trading who are doing this on a regular basis, cementing us as an industry leader. To explore our 1:3 Live Trading Account options you can do so here: Live Account Options
Total DD is 10% and daily is 5%.
Amazing,.