Risk management plays a key role in trading, but its relevance in funded trading accounts is even more prominent due to their model. Funded traders face strict rules that determine performance, and the focus on preventing risk is often greater than the goal of reaching a profit target.
One key risk metric is drawdown, which refers to how much an account’s value is declining. This measure helps traders evaluate potential losses, and most prop firms impose drawdown limits for funded accounts.
Deep losses are far harder to undo than most traders assume, which is exactly why drawdown limits exist: as Ben Carlson explains on A Wealth of Com mon Sense, citing Michael Mauboussin’s study of 6,500 U.S. stocks, the median stock suffered an 85% drawdown and more than half never returned to their previous peak, a reminder that capping a loss early beats hoping to win it back later.
What Is Drawdown in Trading?
In trading, drawdown measures the decline in account value from a previous level. You will often see it expressed as a percentage, but it can also represent an absolute amount.
For example, if a trading account falls from $100,000 to $95,000, it experiences a $5,000 drawdown, which is 5%.
This may seem a relatively small decline at first, but when you try to recover to the previous levels, you realize that you should put in more effort, because the required gain would relate to the current amount, which is smaller. In other words, an account that loses 5% must gain nearly 5.30% to return to its initial value.
The required return to recover the loss increases with the loss amount, as shown here:
| Drawdown | Gain Required to Recover |
| 10% | 11.1% |
| 20% | 25% |
| 30% | 42.9% |
| 50% | 100% |
Given this relationship, prop firms impose maximum drawdown thresholds that terminate traders’ accounts when breached. It refers to the largest peak-to-trough decline registered during a given period.
The metric is important when assessing trading strategies or a trader’s performance.
Traders try to prevent their accounts from falling beyond the stipulated drawdown limit, but there are two types of drawdown concepts: static and trailing. Let’s define each to know which one is better for funded traders.
How Static Drawdown Works
Static drawdown is simple: it sets a fixed loss limit based on an account’s initial value. Unlike traditional maximum drawdown calculations, which measure decline from previous peaks, the static version doesn’t adjust its limit when the account makes profits.
For example, let’s say you trade a funded account and the conditions are as follows:
- Initial balance: $100,000
- Maximum static drawdown: 8%
- Maximum allowed loss: $8,000
We can find the drawdown floor based on this simple formula:
Drawdown Floor = Initial Balance × (1 − Drawdown Limit)
In our example, the minimum permitted limit is $92,000.
Therefore, you would do your best to keep the account value above that threshold. What happens when you generate profits? The drawdown floor remains at the same level, and you have more room for larger losses until triggering account termination.
As you can see, this is the main advantage of static drawdown – profitable trades can increase the available risk buffer.
Obviously, funded traders should also take into account other risk rules, such as daily loss limits.
How Trailing Drawdown Works
Trailing drawdown also limits the permitted loss, but it uses a completely different approach. Specifically, it relies on a moving loss threshold that rises as an account grows to reach new highs.
For example, let’s say you start with a funded account with the same $100,000 in simulated capital, but this time have a trailing drawdown allowance of $5,000. At this point, the account’s minimum permitted value would be $95,000.
However, if you make a profit and the account value increases to $104,000, the trailing threshold moves to $99,000.
Importantly, if you lose $3,000 to reach $101,000, the threshold remains at $99,000, as it doesn’t adjust downward with losses. Therefore, trailing drawdowns usually focus on new peaks when adjusting the threshold.
Some prop firms adjust the trailing limits based on account equity at any given moment or at the end of each trading day. The choice can influence the effectiveness and risk exposure of trading strategies.
Why the Drawdown Model Matters
Both drawdown models are meant to prevent major losses in funded accounts and filter traders. However, they are not the same and affect trading behaviors differently.
With static limits, you get a clearer picture of how much you can risk. You know the minimum account value from day one, and every time you secure a profit, your risk buffer expands as well.
Elsewhere, trailing limits require you to monitor your threshold closely, as new account peaks may raise the limits.
The choice of the program or prop firm offering different drawdown models is especially relevant for strategies that involve volatile assets, such as crypto or certain stocks.
In the end, understanding the math behind drawdown lets you assess funded accounts more accurately.