What is Relative vs. Absolute Drawdown? Must Know!
Hello, traders and aspiring funded traders!
If you are serious about succeeding in the world of proprietary trading (Prop Firm), there is one concept you cannot ignore or misunderstand, which is Drawdown. This term is the heart of risk management, and failure to understand it, especially the fundamental difference between relative vs absolute drawdown, can be the main reason why many challenge accounts fail.
I know, financial terms sometimes sound complicated. However, think of me as your research partner who will dissect this concept step by step, in clear and straightforward language. The goal is not just for you to pass the challenge, but for you to become a responsible capital manager. Understanding the dynamics between relative and absolute drawdown is the first step to becoming a professional trader.
Drawdown is the line between success and rule violation in a Prop Firm. Let's begin.
1. Understanding the Basics: What Is Drawdown?
Simply put, Drawdown (DD) is the percentage or monetary value decline from the peak (highest value) of your account over a specific period. It is a metric used to measure the risk of loss an account might experience.
In the world of Prop Trading, drawdown is the most crucial rule. Every Prop Firm applies a maximum loss limit, which if violated, will cause your account (whether a challenge or funded account) to be closed or terminated (breach).
To avoid fatal mistakes, there are two main types of drawdown you must understand deeply: Absolute Drawdown and Relative Drawdown.
2. Getting to Know Absolute Drawdown: Static Limits in Relative vs Absolute Drawdown
Absolute Drawdown is the simplest and easiest Drawdown concept to calculate.
Definition and Focus
Absolute Drawdown (Absolute DD) refers to the decline in account equity value from your initial balance or initial deposit capital.
This is a loss limit measured solely based on the starting point, without taking into account how much profit you may have accumulated afterwards.
How It Works and Examples
Absolute DD is calculated from the lowest point of your equity compared to the initial account balance.
Simple Formula: $$ \text{Absolute Drawdown} = \text{Initial Balance} - \text{Lowest Equity} $$
Practical Example:
Imagine you buy a challenge account worth $100,000 with a 10% Absolute Drawdown limit.
- Initial Balance: $100,000
- Absolute DD Limit: $10,000 (10% of $100,000)
- Account Blown If Equity reaches: $90,000
Scenario 1 (No Profit): You experience a loss and equity drops to $90,000. Your account is blown. Scenario 2 (After Profit): You successfully gain a profit of $5,000, bringing equity to $105,000. Then, you experience a series of losses. As long as your equity does not touch $90,000, your account is still safe.
Key Point: In Absolute Drawdown, your loss limit remains fixed at the initial balance point, not moving with the profit you generate. This type of Absolute Drawdown provides greater wiggle room after you achieve profit.
3. Getting to Know Relative Drawdown (Trailing Drawdown): The Main Rule of Prop Firms
This is the type of Drawdown that often confuses beginner traders and is most commonly used by Prop Firms—why it is important to understand relative vs absolute drawdown.
Definition and Focus
Relative Drawdown (Relative DD) refers to the decline in account equity value from the highest peak (High Water Mark) your account has ever reached.
Because your loss limit moves (or "trails") as equity rises, Relative Drawdown is often referred to as Trailing Drawdown. This is the mechanism that fundamentally distinguishes relative vs absolute drawdown.
How It Works and Consequences
Relative DD is calculated from your account's current equity peak. Every time your equity reaches a new high, your Drawdown limit will move up.
Core Formula: $$ \text{Minimum Equity Limit} = \text{Highest Equity Ever Reached} - \text{Max DD Percentage} $$
Practical Example (Using a $100,000 Account with 5% Relative DD Limit):
Initial (Day 1):
- Initial Balance: $100,000
- High Water Mark: $100,000
- Blown Account Limit (Minimum): $100,000 - 5% = $95,000
Profit (Day 3):
- You generate $2,000 profit. Equity becomes $102,000.
- New High Peak: $102,000.
- Blown Account Limit (Minimum) MOVES UP: $102,000 - 5% = $96,900.
Further Profit (Day 10):
- You reach $105,000 equity (5% profit target reached!).
- New High Peak: $105,000.
- Blown Account Limit (Minimum) MOVES AGAIN: $105,000 - 5% = $99,750.
Loss (Day 12):
- You experience consecutive losses. If your equity drops and touches $99,750, your account is blown, even though this value is still above the initial $100,000 balance.
Important to Note: If you have achieved significant profit, Relative Drawdown protects the Prop Firm from the risk of you giving back all profits and harming their initial capital. Relative Drawdown ensures that as your account grows, your loss limit also increases, making the Prop Firm safer but demanding extra discipline from the trader.
4. Relative vs Absolute Drawdown: Table of Crucial Differences
The difference between relative vs absolute drawdown is the core of risk management in Prop Firms that every trader must master.
| Feature | Absolute Drawdown | Relative Drawdown (Trailing Drawdown) |
|---|---|---|
| Reference Point | Initial Balance | Highest Peak (High Water Mark/Peak Equity) |
| Limit Stability | Static (Fixed calculated from initial balance) | Dynamic (Moves up following profit) |
| Limit Movement | Does not move, even after profit | Moves up, protecting Prop Firm profits |
| When Does It Stop Moving? | N/A | Usually stops moving (locked) after account reaches certain profit (e.g., after reaching initial balance + 5% profit) |
| Trader Risk | Low after big profit | High, because loss limit keeps "chasing" profit |
| Main Goal | Measure loss from initial capital | Measure loss from peak equity |
Why Do Prop Firms Often Choose Relative Drawdown?
Prop Firms use Relative Drawdown as a highly effective risk mitigation tool.
Imagine a Prop Firm gives you $100,000 capital, and you generate $50,000 profit (equity $150,000). If they only use 10% Absolute Drawdown ($10,000), you could still lose $40,000 of your profit before the account is terminated.
With Relative Drawdown, your loss limit keeps moving upwards. This ensures that the maximum loss borne by the Prop Firm remains small relative to the highest equity ever achieved, thereby maintaining their business sustainability.
Conclusion
Understanding the intricacies of relative vs absolute drawdown is not just theory, but a vital foundation in your trading plan.
If you join a challenge program at a Prop Firm, the standard assumption is you will face Relative Drawdown (Trailing Drawdown). Ensure you always check the specific rules of the company you join.
By mastering this difference, you can design a risk management strategy that not only focuses on reaching profit targets but, more importantly, ensures your loss limits are not violated. This is the mentality that separates amateur traders from responsible funded traders. Success always!
By: FXBonus Team
Post a Comment