The trailing drawdown is a term that prop firms use to define the maximum loss level when trading in a funding challenge or a funded account. This article describes the types of trailing drawdowns and how they work, as well as provides a step-by-step overview of the mechanism.
Types of Trailing Drawdowns
Trailing Drawdowns typically only move to the upside until the current account balance reaches the starting balance + drawdown amount.
Example: Your account balance starts at $50,000, and your drawdown limit amount is $2,000. Your maximum drawdown limit is, therefore, $48,000. The drawdown limit only increases until it reaches the $50,000 level, which is reached at an account balance of $52,000 ($52,000 – $2,000 = starting balance of the account.
However, the trailing drawdown is calculated in two different ways. As you’ll see, the two types make a big difference to your chances of success.
EOD Trailing Drawdown
Prop firms offering an EOD trailing drawdown move the maximum stop loss level up at the end of a trading day after market close. The drawdown level only rises if the account value at the end of the current trading day is higher than ever before.
The end-of-day (EOD) drawdown is the best choice for proprietary traders because only the end-of-day balance causes changes in the overall maximum stop loss level.
Example:
Day 1: Your account balance starts at $50,000, and your drawdown limit is $2,000. Therefore, your maximum drawdown limit is $48,000.
Intraday, the balance, including unrealized profits, goes as high as $51,500, but at the end of the day, your balance is $51,000. Now, the maximum trailing drawdown amount gets deducted from the $51,000 end-of-day balance to $51,000 – $2,000 = $49,000.
Day 2: Your account balance increases intraday to $55,000 and closes at $52.500. Your maximum trailing drawdown level is now set to $50,000.
Why $50,000 and not $50,500, you may ask. That’s because the level typically does not go beyond your starting capital level. However, make sure to check the terms of your prop firm. Some move it to the starting capital level + $100, which is not a big deal, but you have to be aware of it.
Intraday Trailing Drawdown
Prop firms offering an intraday trailing drawdown move the maximum stop loss level up in real-time, intraday, at any time and do not wait until the balance is cleared after market close. The drawdown level always rises if the account value is higher than ever before.
The tricky thing with intraday trailing drawdowns is that they also consider unrealized profits in their calculation. This means if you have a profitable trade that does exceptionally well and lets the profits run without any trade management, you might lose your trading challenge if that open position bounces back in profitability.
That’s why the intraday trailing drawdown is only the second-best choice for prop traders.
Example:
Day 1: Your account balance starts at $50,000, and your drawdown limit is $2,000. Therefore, your maximum drawdown limit is $48,000.
Intraday, the balance, including unrealized profits, goes as high as $51,500. Your stop loss level is now $49,500 in real-time intraday. Your account balance should now not fall below that level intraday because the new trailing stop is already set intraday and does not wait for market close.
Day 2: Your account balance increases intraday to $55,000. Your maximum trailing drawdown level is now set to $50,000.
Why $50,000 and not $50,500, you may ask. That’s because the level typically does not go beyond your starting capital level. However, make sure to check the terms of your prop firm. Some move it to the starting capital level + $100, which is not a big deal, but you have to be aware of it.
Here is the danger: If your account value falls below the $50,000 intraday, you lose the challenge immediately. You don’t have the chance to make it back above the $50,000 trailing drawdown level until the end of the day because the calculation happened intraday.
How Prop Firm Trailing Drawdown Works
A trailing drawdown is the maximum permitted stop loss level in a trader’s account before it gets paused or closed down. It starts at a predefined level (e.g., $5,000 in a 100K account) and trails upwards as profits accumulate, raising the stop loss higher to lock in gains.
However, it always trails down at the initial maximum drawdown limit set.
The trailing threshold stops trailing upwards once the profit target balance is hit. Any profits after reaching the profit target won’t increase the trailing stop further. This way, traders can capture upside potential once the profit target is reached without risking giving back more than the maximum drawdown level, which is typically the initial balance of a prop firm challenge.
So, a trailing drawdown is like an automatically adjusted stop loss that only moves in one direction, upwards. If a loss breaches this trailing stop loss level, the trading account is paused or terminated to protect the firm’s capital as per risk management rules.
Basically, it is a moving stop loss that can never decrease in value, only increase. As the account grows, the permissible maximum drawdown. It provides a flexible risk management mechanism that adjusts the stop loss higher while capping maximum potential loss.
Trailing Drawdown Mechanism
- It starts at a predefined maximum drawdown level set by the prop firm (e.g., $5,000).
- As the trader’s account accrues profits and the account balance grows, the trailing drawdown level also increases to lock in those profits.
- However, the trailing drawdown never decreases below the initial maximum drawdown limit, even if the account balance falls after reaching a higher level.
- Once the trader’s account balance hits the profit target set by the prop firm, the trailing drawdown stops trailing upwards. Any losses after this point will not increase the drawdown limit further.
- If a trader’s losses exceed the current trailing drawdown limit at any point, the trading account is paused or closed to protect the firm’s capital.
Note: The drawdown trailing typically ends once the drawdown level reaches the account’s initial balance or the initial balance + $100. Example: Initial Balance = $50,000, drawdown amount = $2,000. The trailing of the drawdown amount stops once the account balance reaches $50,000 + $2,000 (EOD or real-time, depending on your prop firm). In some cases, the prop firm adds another $100 to the level. Make sure to check the exact parameters before you start trading.
