In the world of prop trading, managing risk is crucial, and one of the most important risk management rules is the daily drawdown limit. This rule ensures that traders don’t incur excessive losses in a single day, protecting both the trader and the firm. There are different ways to calculate daily drawdown, and it’s essential to understand how each works.
At AlphaPropTraders, we currently use the equity-based drawdown, as it’s considered the most advantageous and easiest for traders to calculate. However, it’s important to be aware of the different types of daily drawdown you might encounter in the industry. Below, we’ll explain the three common methods:
1. Balance-Based Daily Drawdown
In this method, the drawdown is calculated based solely on the account balance at the end of the day. Any open trades are not considered in this calculation, making it more predictable for traders.
Example: If a trader has an initial balance of $10,000 and gains $300 in closed trades by the end of the day, the new balance is $10,300. The 5% daily drawdown limit for the next day will be calculated from the new balance, meaning the maximum allowable loss for that day is $515 (5% of $10,300). In this case, open trades don’t affect the drawdown calculation.
2. Equity-Based Daily Drawdown (Used by AlphaPropTraders)
The equity-based drawdown is calculated based on the account’s equity, which includes both the balance and any open trades. This method provides a more dynamic view of your risk and adjusts based on unrealized gains or losses from open positions.
Example: If a trader’s balance is $10,300, but the equity at the end of the day, including open trades, is $10,700, the 5% drawdown for the next day will be calculated from the equity. This means the maximum loss allowable is $535 (5% of $10,700). Unlike the balance-based method, the current equity, which fluctuates with open trades, is used for the drawdown calculation.
At AlphaPropTraders, we use this equity-based method because it gives traders a real-time reflection of their overall risk and potential losses. It’s the most transparent way to manage drawdown, as it accounts for all open positions.
3. Combined Equity/Balance-Based Daily Drawdown
This method uses both the balance and the equity but calculates the drawdown based on whichever is less favorable to the trader, typically to further minimize risk.
Example: If a trader’s balance is $10,300, but their equity is $10,700 due to open trades, the daily drawdown will be calculated from the higher value, which in this case is the equity of $10,700. Therefore, the allowable loss is $535 (5% of $10,700), even though the balance was lower. This method combines the strictness of both the balance and equity approaches to ensure that traders don’t over-leverage.
4. Fixed Initial Balance Drawdown
This is the simplest method but can be the most restrictive for traders. The daily drawdown is always calculated from the initial balance, regardless of how much the account grows over time.
Example: If the initial balance is $10,000, the daily drawdown limit is fixed at $500 (5% of $10,000), regardless of how much the account balance grows. Even if the balance increases to $10,300, the maximum allowable loss would still be $500. This method doesn't account for the trader’s growth in the account.
AlphaPropTraders and Daily Drawdown
At AlphaPropTraders, we believe in providing a fair and clear method for calculating daily drawdown, which is why we use the equity-based approach. This allows traders to understand their real-time risk, as it includes both closed positions and unrealized gains or losses from open trades.
Our equity-based drawdown method is designed to be the most straightforward for traders, ensuring they can manage their risk effectively and stay within the drawdown limits without confusion. Should we make any changes to our drawdown calculations in the future, we will announce them clearly to keep our traders informed and up-to-date.
Conclusion
Understanding how daily drawdown is calculated is critical for managing risk and staying within the rules of prop trading. Whether it’s based on balance, equity, or a combination of both, each method has its pros and cons. At AlphaPropTraders, we prioritize transparency and ease of calculation for our traders by using the equity-based method.
If you have any questions about our daily drawdown rules or how they apply to your trading, feel free to reach out to us. We’re here to ensure that you have all the tools and knowledge to succeed.
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