In prop trading firms, the daily drawdown rule plays a key role in preserving capital and maintaining the existence of traders. This rule helps to limit daily losses, minimizing the possibility of the account being burned after just a few orders. So what is daily drawdown? Let’s learn how to calculate daily capital withdrawal and effective risk management strategies through the following article.
What is daily drawdown?
Daily drawdown is an important risk management rule in trading, which specifies the maximum loss a trader can lose in a day. When the loss limit is reached or exceeded, the account may be warned, violated or terminated, depending on the assessment probation period or the use of an account that has been actually funded by the prop company.
Daily drawdown rule is set by proprietary trading companies to protect capital and maintain discipline in the trader’s operations. This limit is set based on a percentage of the initial balance or equity value, helping to control the maximum risk level during the day and prevent large losses that can affect the account.
Why do proprietary trading firms use the daily drawdown rule?
Brokerage firms allow traders to access large amounts of capital, but also impose strict risk management requirements. Therefore, to protect the firm’s capital as well as the investor’s trading discipline, the daily drawdown rule is set to limit the maximum loss in a day.
- Daily drawdown rule is intended to limit the psychological shocks that traders may experience and protect the company’s capital from significant losses.
- This rule also encourages traders to stay disciplined and avoid making hasty decisions without careful consideration.
- Helps traders focus on long-term stability and consistency instead of chasing short-term profits with risky “all-in” strategies, thereby creating a more sustainable trading platform.
This rule aims to cultivate traders’ discipline and emotional stability, while protecting the company’s capital. Traders are forced to have a clear plan and manage their capital reasonably instead of “betting” on high-risk orders or acting impulsively. This not only helps businesses minimize risks, but also encourages traders to pursue stability and long-term growth instead of risky short-term profits.
Forms of daily drawdown
Intraday daily drawdown
Intraday daily drawdown index reflects the sharpest decline in account value, from highest peak to lowest bottom within the same trading day. The intraday daily drawdown is usually determined throughout the trading day, taking into account changes in account value and price fluctuations. By measuring this indicator, traders and brokerage firms will be able to more accurately and comprehensively assess the risk and volatility of their positions by clearly identifying potential losses.
End of day daily drawdown
End of day daily drawdown is an indicator that shows the largest decrease in value of an account or financial instrument at the end of a trading day compared to its peak, measured from the highest high to the lowest low. While the closing price is the main focus, the end of day daily drawdown calculation is based on price movements and changes in account value throughout the trading session. This indicator helps traders and brokerage firms evaluate overall performance and the level of risk incurred by providing them with a summary of the maximum loss for the day.
How to calculate daily drawdown
Depending on their capital management rules, each brokerage firm will calculate the daily drawdown rule in different ways to control risk. Among them, there are 3 popular calculation methods such as:
Case 1: Fixed daily drawdown
For example, with an account of around $100,000, the maximum daily loss would be around $5,000 if the daily drawdown is set at 5% of the initial capital. It is important to remember that this figure remains the same regardless of whether the trader has made or lost money previously.
Case 2: Trailing daily drawdown
For example, the initial limit for a $100,000 account is $5,000 if the daily drawdown is calculated at 5% based on equity (capital plus current profits). The allowed drawdown will increase to $5,100 when the trader earns an additional $2,000 in profits (equity = $102,000).
Case 3: Based on balance or equity
Margin (the amount remaining after closing a position) is used by some proprietary brokers to calculate daily drawdowns, while others use equity (which includes any temporary gains or losses). Even if a trader’s position returns to breakeven at the end of the session, just one negative order during the day can put the trader in violation if equity is used for the calculation.
How to prevent daily drawdown in trading
Traders must adhere to the daily drawdown rule to pass the assessment and keep their capital in their account. This helps to minimize the possibility of unnecessary risks. These useful tips will help you apply them more effectively.
Set daily risk limits
In a worst case scenario, you could lose 4 trades in a row before hitting the daily drawdown rule of 4%, assuming you stick to your risk management rule of only risking 1% of your capital per trade. This gives you some “room” to avoid breaking the rule in the first place. In addition to limiting your daily losses, this strategy also allows you to maintain discipline and focus on strategy quality rather than trade size.
Limit overtrading
One of the key principles of following the daily drawdown rule is to never increase your position size or engage in “revenge trading” after a loss. Many traders open large positions or increase their lot size in an attempt to recover quickly, but this often leads to a risk of blowing up and ruining their account. Instead, stick to your original trading discipline, accept losses within your limits, and take the time to re-evaluate your approach.
Split trading volume
To manage your risk, you should divide your capital into several orders instead of putting all of it into one large order. This strategy allows you to flexibly adjust your position and reduce psychological pressure when the market fluctuates unfavorably. You can also take profits or cut losses in parts by dividing them into many small orders, avoiding the situation where a wrong choice can significantly affect your account. This is an important tactic to follow the daily drawdown rule.
Track equity movements
You must carefully monitor your losses throughout the trading day to avoid violating the daily drawdown rule. Many traders only look at their balance when they close a position, but some brokers actually use their equity, including any short-term gains or losses, to determine their drawdown. This means that even if it recovers at the end of the day, a single losing position can push you over the limit. Therefore, you can better manage your risk by constantly monitoring your equity.
Take profit early to preserve profit
Unrealized profits in trading are temporary and can disappear quickly when the market reverses. Therefore, it is important to use risk management tools to protect profits. To lock in profits, you can apply partial profit taking techniques, stop loss orders, and trailing stop orders. These steps help to form a more disciplined and safe trading mindset, while minimizing the possibility of returning to a losing position.
Use stop loss orders
Without precautions, the unpredictable and volatile nature of the financial markets can wipe out your account in a matter of minutes. Unexpected price movements, sudden news releases, or sharp reversals can all lead to uncontrollable losses. Therefore, it is important to always place a stop loss order in every trade in the daily drawdown rule. In addition to minimizing risk, a stop loss order also protects your money, ensuring you are safe enough to trade for the long haul.
Record and track transactions
It is important to record and track each trading position, but it is more important to pay attention to the emotions and reasons behind each decision. A trading journal shows how you react to risk and volatility and helps you see the numbers. Understanding the motivations behind your trades, your mental state, and the market environment can help you adjust your strategy, improve your discipline, and improve your long-term trading performance.
Conclude
The daily drawdown rule is not only a technical limit but also a tool to help traders practice discipline and control emotions. By strictly following this rule, you can protect your account and maintain stability in your trading journey. Although each proprietary brokerage firm uses a different calculation method, the basic principle is still effective risk management. Think of the daily drawdown rule as a “shield” against market volatility.
Frequently asked questions
What does the 5% daily drawdown mean?
You are only allowed to lose a maximum of 5% of your account in a single trading day if you follow the 5% daily loss rule. For example, the maximum daily loss for a $50,000 account is $2,500. You have exceeded the limit if your equity falls below $47,500 during the course of trading. This rule forces traders to closely manage risk, prevent uncontrollable losses, and protect the stability of their accounts.
Does the daily drawdown reset after each trading day?
Yes, when a new trading day starts, the daily drawdown is usually updated. The drawdown limit is recalculated from the beginning of the next trading session, based on the trading results and account movements of that day, instead of cumulatively from the previous day.
What happens when you violate the daily drawdown?
Exceeding the daily drawdown limit often results in serious consequences, depending on the exchange or brokerage firm’s policies. Some common cases include immediate account lockout, contract termination, or limited trading rights for the rest of the day, in order to protect funds.