Drawdown is the difference between the balance of your account, and net balance of your account. The net balance takes into account open trades that are currency in profit, or currently in loss.
If you account net balance is lower than your account balance, this is called drawdown.
A currency trading system that begins with a balance of $100,000 that sees an equity drop down to $95,000 has seen a $5,000 drawdown.
Drawdowns will also describe the likely survivability of your system over the long run. A large drawdown puts an investor at an unenviable position. Consider this:
A client that endures a 50% drawdown has a large task ahead of her or him. In short, on the reduced equity position, the trader most have a 100% return on the reduced capital stake just to break even.
Many investors or fund managers on Wall Street are ecstatic with around 20% for the year.
As you can imagine, a trader who suffers a drawdown is best served to simply re-adjust their system as opposed to aggressively trading there way back to break even. Typically, an aggressive approach to get their capital back to break even has the opposite reaction. Why is this? They often use leverage and over trade in order to get their trading account back to even.
When traders use too much leverage, one bad trade can have disastrous effects and often does. I sadly see this all too often. In short, traders are either too aggressive or too confident, which leads to sharp losses or unwillingness to accept a trade as a loser that should be cut.
There is an old adage in trading that one trade will rarely make your trading career but one bad trade can certainly end your career.
If you'd like to read a book that described the emotional toll of taking a draw down, you can read What I Learned Losing $1,000,000 by Jim Paul and Brian Moynihan. I've read and enjoyed this book and it talks about how a trader lost his career, significant amounts of families fortune as well money of his friends as well by taking a large drawdown.
Additionally, this book shares excellent tips on how to overcome this common pitfall of traders without a plan that are likely to be emotionally driven.
One of the greatest tips in the book is to have a predetermined stop loss point on your trade before entering. This will limit the amount of a drawdown you will take. Also, you will be able to stand back once you've entered the trade knowing that if that level is hit, you're out of the trade no questions asked. The mistake a lot of traders make is trying to negotiate with the market as to whether or not they should stay in the trade. It's a mistake because you'll be emotionally driven and likely to do the thing that is less painful at the time but more beneficial down the road.