Money Management in Stock Indices - Drawdown & Maximum Drawdown

In stock index one of the most crucial concepts is money management; how do you as a trader manage your account so that as you make profits in the long-term.

To know about money manage you are required to know the following concepts as a trader.

Draw-down

Drawdown is the amount of money you as a stock indices trader can lose on a single trade in stock index.

Example of Drawdown:

As a trader if you have $10,000 in your account and you open a trade, & the trade transaction makes a loss of $1,000 from one single trade your drawdown is:

Drawdown = $1,000/$10,000*100 = 10% of your account

Maximum Drawdown

Maximum draw-down is the overall total amount you have lost on your trading account before you start earning and making profits.

Example of Maximum Drawdown:

As a trader if you have $10,000 in your account and you open a 3 losing trades of a total of $3,000 before making 4 winning trades of $4,000, then your maximum drawdown is:

Maximum Draw-down = $3,000/$10,000*100 = 30% of your trading account

To better manage your money as trader it's best to keep this drawdown per trade to a minimum. The recommended is 2 % drawdown per trade. This way as a trader you'll control the risk per trade & also minimize the maximum drawdown.

For Example if there are two traders one uses 2 % drawdown per trade & the other uses 10 % drawdown per trade position, if both oof--theem make 15 losing trade positions in a row, then the 2 accounts will be as shown and illustrated below:

Money Management in Indices - Money Management Trade Indices Risk Management

After 15 losing trades a trader using 2 % draw-down would still have 75% of their total capital, while a trader using 10% drawdown would only have 23% of their total capital.

This illustration although it's nearly not possible to have a losing streak of 15 consecutive trades in a row, shows that using 2 % drawdown will preserve your capital & help keep you in this trading game for longer and you will be more likely to make profits in the long-term.

This is also because it will be easier to break even if you only lose a little of your capital rather than losing most of your capital, as is illustrated below:

Money Management in Stock Indices - Stock Index Risk Calculation

The way break-even is calculated in terms of % is:

10 percent% loss for $10,000 your capital is $9,000 dollars you need to earn $1,000 dollars to get to $10,000

Hence $1,000/$9,000*100 = 11 %

30 % loss for $10,000 your capital is $7,000 dollars you need to earn $3,000 dollars to get to $10,000

Hence $3000/$7,000*100 = 43 %

70 % loss for $10,000 your capital is $3,000 dollars you need to make $7,000 to get to $10,000

Therefore $7000/$3,000*100 = 233%

From these examples above the more the maximum drawdown the harder it's to get back to break even & to make profits.

This is why it is best to use 2 % risk drawdown so that as to keep your drawdown & maximum drawdown to a minimum & this way improve your chance of making profits in the market.

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Money Management in Stock Indices - Drawdown & Maximum Drawdown

Draw-down

Maximum Drawdown