Drawdown Types Explained in Prop Trading Firms

What’s Account Drawdown?

Drawdown simply refers to the largest decline in your account balance from a peak. In prop firms’ programs, it dictates the point at which your evaluation fails. Imagine a roller coaster ride – the peak is your highest account value, and the drawdown is the steepest descent from that peak. The lower the allowable drawdown, the less wiggle room you have for trading mistakes.

Why Prop Firms Use Drawdown?

Prop firms primarily use drawdown for two key reasons:

• Risk Management: Drawdown incentivizes good risk management by dynamically adjusting the available buffer zone based on your trading performance. This discourages excessive risk-taking and encourages strategies focused on capital preservation.

• Adaptability to Different Strategies: Drawdown allows prop firms to cater to various trading styles. Aggressive traders can opt for Live Trailing Drawdown for potentially lower evaluation fees, while risk-averse traders might prefer EOD or Trailing Top of Equity Drawdown for a more controlled environment.

Understanding Drawdown Types

Absolute Drawdown (Balance Based)

The gold standard, offering the most breathing room. The drawdown limit is a fixed percentage or dollar amount of your starting account balance and remains constant throughout the evaluation, regardless of your trading activity or open positions.

Example: With a $250,000 account and a 10% drawdown, the threshold stays at $225,000.

• Who Benefits: Ideal for risk-averse traders or those with strategies prone to short-term swings.

• Pros: Maximum flexibility, less pressure on managing intraday fluctuations.

• Cons: Evaluations with Static Drawdown typically cost more due to the lower risk involved for the prop firm.

Relative Drawdown (Equity Based)

Measures the decline in your account’s value compared to the highest point it’s ever reached. It’s expressed as a percentage, giving you a more nuanced understanding of potential losses than a simple account balance comparison.

Relative Drawdown (as a percentage) = (Drawdown / High-Water Mark) x 100%

For instance, if your account reached a peak of $10,000 and then dropped to $8,000, the drawdown would be $2,000. The relative drawdown would be 20% (since $2,000 divided by $10,000 is 0.2, which when multiplied by 100% becomes 20%).

 

1- Live Trailing Drawdown

The holy grail for prop firms, but also the trickiest. Here, the drawdown limit constantly adjusts to your highest account balance, including open positions. This demands exceptional discipline and risk management.

• Example: Imagine a $50,000 account with a $3,000 drawdown. A profitable trade of $500 increases your balance to $50,500, but the drawdown threshold also moves to $47,500. Even breakeven trades reduce your available drawdown buffer.
• Who Benefits: Scalpers and those using limit orders to maximize profits can leverage this drawdown type effectively.
• Pros: Low evaluation fees due to high difficulty.

2- End of Day (EOD) Drawdown

A more forgiving option. The drawdown limit only adjusts at the day’s end if a new high is reached. Intraday fluctuations don’t affect your buffer unless you breach the limit altogether.

• Example: With a $50,000 account and $2,000 drawdown, a $2,000 profit by day’s end raises the threshold to $50,000. However, a profit earlier that’s reversed later wouldn’t affect the drawdown.
• Who Benefits: Ideal for traders who focus on daily performance and don’t mind short-term fluctuations.
• Pros: Less stressful than Live Trailing, often offered at competitive prices.

3- Trailing Top of Equity Drawdown

A middle ground, this type only adjusts when a closed trade sets a new account high. Open trades don’t impact the limit.

• Example: In a $50,000 account with a $2,000 drawdown, a closed trade with a $1,000 profit raises the threshold to $49,000. A losing trade wouldn’t affect it.
• Who Benefits: Offers more flexibility than Live Trailing while being stricter than EOD. Suitable for a wider range of trading styles.
• Pros: Good balance between difficulty and cost, often found in both futures and forex programs.

While Live Trailing Drawdown, EOD Drawdown, and Trailing Top of Equity Drawdown are the most common types of relative drawdown, there can be variations and additional considerations depending on the specific prop firm program. Here’s a deeper dive:

• Time-Based Adjustments: Some programs might have a hybrid approach, combining elements of EOD and Trailing Top of Equity. The limit might adjust only at the end of the day, but only if a new high is reached within a specific timeframe. This adds another layer of complexity and risk management.
• Profit Capture Levels: A program might offer a variation of Trailing Top of Equity where the limit adjusts only when a closed trade captures a certain percentage profit (e.g., 5%). This incentivizes taking profits and locking in gains to create a buffer for potential future losses.
• Multiple Drawdown Limits: Some prop firms might have separate drawdown limits for different metrics, such as total account value and unrealized floating profit/loss (open positions). This provides a more nuanced view of risk and can prevent situations where a large unrealized loss in open positions triggers a violation even with a positive overall account balance.

Choosing the Right Drawdown

Now that you understand the different drawdown types, let’s explore how to choose the best fit for your goals: Here are some factors to consider when choosing a relative drawdown type:

• Your Trading Style: Aggressive traders might handle Live Trailing Drawdown well, while risk-averse traders might prefer EOD or Trailing Top of Equity Drawdown.
• Risk Tolerance: Consider how much risk you’re comfortable with and how much buffer you need to feel secure during the evaluation.
• Evaluation Cost: Programs with stricter drawdown rules (Live Trailing) often have lower evaluation fees due to the higher risk they involve for the prop firm.
• Program Complexity: Some variations of relative drawdown might add complexity to your trading decisions. Choose a type you understand and can manage effectively.

Real Examples

Let’s take a closer look at drawdown types offered by two popular prop firms’ programs: FTMO and FundedNext, without revealing specific product names.

FTMO (Static Drawdown)

• Account Sizes: Vary depending on challenge chosen (e.g., $100,000, $250,000)
• Drawdown Limit: Fixed percentage (e.g., 10%)
• Unique Drawdown Feature: None (Classic static drawdown)

FTMO is known for its static drawdown structure. This offers a clear advantage – the drawdown limit remains constant throughout the evaluation, regardless of your trading activity. It provides a safety net for risk-averse traders or those with strategies prone to short-term volatility. However, evaluations with static drawdown typically cost more due to the lower risk involved for the prop firm.

FundedNext (Multiple Drawdown Options)

• Account Sizes: Vary depending on challenge chosen (e.g., $50,000)
• Drawdown Limit: Varies based on challenge type
• Unique Drawdown Feature: Offers challenges with different drawdown structures (e.g., static, trailing top of equity)

FundedNext provides more flexibility with drawdown types. They might offer challenges with:

• Static Drawdown: Similar to FTMO, providing a fixed buffer zone.
• Trailing Top of Equity Drawdown: This option allows the drawdown limit to adjust only when closed profitable trades set new account highs. Open positions don’t affect the limit, offering a balance between static and live trailing drawdown.

This flexibility allows traders to choose a drawdown type that aligns with their risk tolerance and trading style. However, it’s important to carefully compare the specific drawdown rules and evaluation costs associated with each challenge type before enrolling.

Drawdown-Risk Management

Understanding drawdown is crucial for prop trader hopefuls, but it’s only one piece of the puzzle. Drawdown works hand-in-hand with risk management, forming the foundation for a successful evaluation. Here’s how drawdown can inform your risk management strategy and minimize the chances of violating the limit.

Drawdown as a Red Line, Risk Management as the Lifeline

Drawdown acts as a red line – a violation leads to evaluation failure. Risk management, on the other hand, is the proactive approach to staying well above that line. By understanding how drawdown works for different types (static, EOD, trailing, etc.), you can tailor your risk management plan accordingly.

Here’s how drawdown awareness empowers your risk management:

• Position Sizing: Knowing your drawdown limit helps you determine the appropriate position size for each trade. A smaller drawdown necessitates smaller positions to avoid exceeding the limit with a single losing trade.
• Stop-Loss Orders: Strategic stop-loss placement becomes even more critical. By setting tighter stops for trades with higher risk, you limit potential losses and protect your drawdown buffer.
• Risk-Reward Ratio: Drawdown emphasizes the importance of a positive risk-reward ratio. Aim for trades with the potential profit outweighing the maximum risk allowed by your drawdown limit.
• Trading Frequency: Aggressive trading styles with frequent entries and exits can eat away at your drawdown buffer, especially with live trailing drawdown. Consider adjusting your trading frequency based on the chosen drawdown type.

Practical Risk Management Tips

• Backtest Your Strategy: Before risking real capital in an evaluation, test your strategy with historical data to understand its drawdown potential. This helps you choose a suitable drawdown type and refine your risk management approach.
• Start Conservative: Begin with smaller position sizes and tighter stop-loss placements, especially if you’re new to prop firms or using a strict drawdown type like live trailing. As your confidence grows, you can gradually increase risk exposure.
• Diversify Your Portfolio: Diversification helps spread risk across different markets or asset classes. This can be particularly beneficial when dealing with a limited drawdown buffer.
• Monitor Your Drawdown Closely: Track your drawdown throughout the evaluation and adjust your trading strategy accordingly. If you find yourself approaching the limit, consider reducing position sizes or taking a break to re-evaluate your risk management approach.
• Focus on Process, Not Profits: During evaluations, prioritize sticking to your trading plan and risk management rules over chasing immediate profits. Disciplined trading habits are key to long-term success in funded accounts.

The Bottom Line

Drawdown is just one piece of the puzzle. Consider these additional factors when choosing a prop firm program:

• Daily Drawdown: Some programs have separate daily limits to prevent excessive intraday risk.
• Evaluation Cost: Higher drawdown flexibility often translates to a higher evaluation fee.
• Program Perks: Some programs offer features like profit-sharing or career paths after successful completion.

A seemingly cheaper program with a harsh drawdown can be a false bargain. Choose the option that aligns with your trading style, risk tolerance, and budget to maximize your chances of becoming a funded trader.

FAQs

Can I negotiate the drawdown limit with a prop firm?

Generally, not. Drawdown limits are set by the prop firm to manage their risk. However, some firms might offer different challenges with varying drawdown structures (static vs trailing).

What happens if I violate the drawdown limit?

Violating the drawdown limit usually leads to failing the evaluation and losing your initial capital (if any). Some prop firms might offer a chance to restart the evaluation for an additional fee.

How does leverage affect drawdown?

Higher leverage amplifies both potential profits and losses. This can make it easier to breach the drawdown limit, especially with stricter drawdown types like Live Trailing.

Are there any prop firms without drawdown rules?

Very few, if any. Drawdown is a widely used risk management tool for prop firms to minimize their losses. However, some firms might offer challenges with more lenient drawdown rules, like a higher percentage or a combination with daily drawdown limits.