When it comes to trading with proprietary (prop) firms, drawdowns are a crucial concept to understand. Most prop firms set drawdown limits to control risk, but not all drawdown policies are created equal. Some firms may not be fully transparent about how their drawdown policies impact traders’ performance and payouts. Here’s what you need to know about trading drawdowns, the different types used by prop firms, and what firms might not be telling you.
What Is a Drawdown?
In trading, a drawdown refers to the peak-to-trough decline in a trader’s account balance over a specific period. It represents the largest loss a trading account has sustained before a recovery. Managing drawdowns is essential to long-term profitability and risk management, as high drawdowns can quickly erode an account balance.
Prop firms use drawdowns to set risk parameters for funded traders, limiting the amount of loss an account can endure. These rules are typically enforced to protect the firm’s capital, but the details of the drawdown structure can have a significant impact on a trader’s strategy.
Types of Drawdowns in Prop Trading
- Static Drawdowns: A static drawdown is a fixed drawdown limit based on the initial account balance, not the peak balance. For example, if a trader starts with $100,000 and has a static drawdown of $6,000, they must avoid dipping below $94,000. This drawdown limit stays consistent regardless of account gains, giving traders a fixed risk level to manage.
- Trailing Drawdowns: A trailing drawdown limit adjusts as the trader’s account balance grows. For instance, if a trader starts with $100,000 and grows their account to $110,000, a 6% trailing drawdown would increase in tandem, adjusting based on the new peak. However, this can also mean that a single large trade or even a series of small losses after reaching a peak can quickly result in a rule violation. Trailing drawdowns are particularly challenging for traders because they constantly change, tightening limits as traders succeed.
- Daily Drawdowns: Daily drawdowns limit the maximum loss a trader can incur within a single trading day. For example, a prop firm might set a 3% daily drawdown on a $100,000 account, meaning the trader must avoid losing more than $3,000 in a day. Daily drawdowns help firms limit single-day risk exposure, but they can add pressure on traders to close losing trades prematurely or risk disqualification.
What Prop Firms Don’t Tell You About Drawdowns
- Trailing Drawdowns Can Hamper Growth: While trailing drawdowns protect the firm’s capital, they can severely restrict a trader’s ability to compound returns. As the account grows, the trailing drawdown continues to increase, effectively tightening the leash. This often forces traders to trade more conservatively, restricting their ability to take advantage of profitable trends.
- Drawdown Limits Can Trigger Stress and Influence Trading Decisions: Having strict drawdown limits—whether static, trailing, or daily—can psychologically impact a trader. The pressure of avoiding drawdown violations can lead traders to close positions early or make overly conservative trades, which can reduce profit potential. While drawdowns are essential risk management tools, the added stress can alter trading behavior, often without firms addressing this upfront.
- Trailing Drawdowns Are Designed to Limit Firm Liability, Not to Help Traders: Trailing drawdowns are highly beneficial to the firm, as they limit the firm’s liability by progressively tightening the drawdown limit as the account grows. For traders, however, they can feel punitive, especially if the trader has grown their account significantly. By not clarifying the effect of trailing drawdowns, some firms may give traders false confidence in their profit potential.
- Not All Drawdowns Are Calculated the Same Way: Some firms calculate drawdowns based on balance, while others use equity. For example, balance-based drawdowns don’t take open positions into account, only registering losses when trades are closed. Equity-based drawdowns, on the other hand, consider floating losses on open trades, which can be more restrictive for active traders. Understanding how a firm calculates drawdowns is crucial, but this information isn’t always clearly communicated.
- Drawdowns Are Often Tied to Challenge Failures: Drawdown violations are one of the most common reasons traders fail challenges, which can lead to costly reattempts. Firms that depend on revenue from challenge fees may set tight drawdown limits to increase the likelihood of reattempt purchases. It’s important to understand how these limits are structured and whether they make it realistically possible to complete a challenge without constant stress or failure.
How to Approach Drawdowns in Prop Trading
- Choose Firms with Transparent and Fair Drawdown Policies: Look for firms that provide clear explanations of their drawdown policies, whether static or trailing. Static drawdowns offer consistency and predictability, while trailing drawdowns demand extra attention and management. Opt for firms with reasonable limits and transparent calculations to avoid surprise restrictions.
- Understand Your Firm’s Calculation Method: Clarify whether the drawdown is based on balance or equity, as this will influence how much room you have for floating losses. Knowing the exact calculation method helps you adjust your trading strategy to fit the firm’s rules, reducing the risk of inadvertent violations.
- Focus on Risk Management to Stay Within Drawdown Limits: Having a strong risk management strategy is essential when trading with any prop firm. Position sizing, stop losses, and overall risk management play a significant role in managing drawdowns and avoiding violations. The goal is to stay comfortably within drawdown limits without sacrificing potential gains.
- Look for Firms that Offer Flexible Terms: Some firms, like MDTC (Million Dollar Trader Challenge by IFT Trader Challenge), offer static drawdowns with no time limits on challenges. Firms that provide flexibility with retry options and reasonable profit-sharing terms show that they are more invested in trader success than in collecting reattempt fees.
The MDTC Difference: A Drawdown Policy Focused on Trader Success
At MDTC, we understand the impact of drawdowns on trader performance, which is why we have implemented trader-friendly policies to support success:
- Static Drawdown Based on Initial Balance: Our $1M account comes with a max drawdown of $100,000 that remains consistent, offering traders a predictable and stable limit without the restrictions of a trailing drawdown.
- No Time Limits for Challenges: MDTC gives traders the freedom to complete challenges at their own pace, removing the pressure that often comes with arbitrary deadlines. This approach fosters disciplined, thoughtful trading over rushed decision-making.
- Transparent, Simple Rules: MDTC’s drawdown policy is straightforward, with clearly defined limits and a transparent structure. Our goal is to empower traders to succeed without the stress of complex, shifting drawdown restrictions.
By prioritizing transparency, fairness, and support, MDTC offers a prop trading environment where traders can focus on building sustainable strategies, achieving real growth, and enjoying greater flexibility in their trading journey.
