When you signup under a prop firm like MyForexFunds, FTMO, TFT for an account they don’t just unconditionally give you an account. The accounts you purchase from these prop firms come with a set of rules. Some of these rules are there to minimize prop firms’ risk exposure and some are for keeping traders on their toes so that they don’t do stuff that might potentially risk their accounts. In short, these rules keep traders in shape.
The most common rules are
- Daily Drawdown,
- Overall Drawdown,
- News Restrictions,
- EA Restriction, etc.
And, a trader under any circumstance can not break these rules. Break of rules may result in your account getting breached and suspended.
Today we are going to discuss how some prop firms calculate their daily drawdown. Because many profitable traders do not realize the way drawdowns are calculated and lose their accounts for silly reasons.
There are mainly two methods that most prop firms adapted to.
- Equity-based drawdown,
- Balance-based drawdown.
Let me clear this out real quick so that it’s easier to follow along.
Balance is basically the sum of your capital plus or minus the profits or losses you booked. Let’s say, you bought a $15000 account and made a profit of $200 on your first day. Now, your balance is $15200 cause you have booked the profit
And, equity is the balance of your account, summed up with the profits or losses from a currently running trade.
Let’s imagine another scenario where you have bought a $15000 account and you have a trade running in profit of $200 (which you haven’t closed yet). So you have $200 (from the running trade) and your initial account balance is $15000. With the running trade’s profits combined with your balance makes your equity $15200. And if you have the running trade-in profit, then your account’s equity would show you $14800 but your balance would still remain $15000. See, it’s simple right?
In most prop firms, the daily drawdown limit is 5% and, the overall drawdown is 10%. In the scenario of a $15000 account, the overall drawdown limit is $1500 and the daily drawdown is $750. Some prop firms like FTMO, TFT, etc. like to keep it simple and apply the 5% limit on your initial balance. That means if you buy a $15000 account, your daily drawdown would be $750 and you can’t lose more than $750 within a day and overall you can’t lose 10% of your initial balance which is $15000. The drawdown limit will not increase as you keep profiting. The daily drawdown will remain the same as these prop firms take the initial balance into account. So even if you make an extra $10000 profit, your daily drawdown will still remain $750 (5% of your initial balance). This method of drawdown calculation is most commonly known as the balance-based drawdown or absolute drawdown.
On the other hand, some prop firms like MFF/MyForexFunds added their own touch to this rule. They like to apply the 5% daily cap on equity or balance whichever is higher. That means if you have a $15000 account and on that account, you have a running trade that is in profit with $600 during the server reset time which is 00:00 GMT+3 then that makes your equity $15600, higher than your balance and thus they apply the 5% limiter on your equity. 5% of $15600 is $780. Basically, in the new day, your account’s equity or balance neither can go below $14820 whereas in balance-based prop firms you still could have gone down to $14250.
Let’s imagine, your running trade, which was in $600 profit the previous day, flips on you and goes in a loss of -$180, can you guys guess what will happen? If you are thinking what I am thinking then you are absolutely right. YOUR ACCOUNT WILL BE SUSPENDED FOR VIOLATING THE DAILY DRAWDOWN RULE.
But, equity-based drawdown also comes with a major pro. Whereas in the balance-based prop firms, your daily drawdown stood absolute at 5% of the initial balance but in equity-based balance that’s not the case. In equity-based firms, your daily drawdown will increase as you keep profiting. Because, their rule says, that they will apply the 5% daily drawdown on equity or balance, whichever is higher. So, as your equity or balance gets higher, your margin of losses will also widen along with your account size/equity.
At the end of the day, both rules are there to shape traders’ behaviors and so far, I can confidently say that it is one of the most successful rules implemented in prop firms. As it rewards those with skills and saves prop firms from rewarding unskilled traders.
It’s gonna be a whole new wave of debate if we were to choose the best daily drawdown calculating method. So, we will take the middle ground and let you guys decide. WHICH ONE DO YOU PREFER? LET US KNOW IN THE COMMENTS.
Enjoyed this article? Be sure to check out How to Start Forex Trading on a Budget