Trend drawdown is computed from pure price action and so is the best way to determine the trend reliability. It simply tells you how deep the price went against the current trend. You will appreciate this method in the next paragraph “Protecting against volatility”.
Now, take a look at the chart below.
The blue line indicates the deepest move against the current trend. In this example it is 233 pips. The whole move in this chart is 882 pips.The trend drawdown is:
233 / 882 = cca 26%
Not bad. Conservative traders would prefer the trend drawdown to be below 20% as it is more reliable. The ‘big dogs’ prefer trends with drawdown even below 15%. Such trends exist almost every day in at least one Forex chart.
Trends with drawdown below 10% are very rare, but when they appear, they are gold mines – you can easily achieve a winning percentage above 90%.
The lower trend drawdown = the more reliable trend = the greater success rate
= the more consistent profit!
One more important note:
How many bars should we use to define the trend? We have used 200 bars in the examples above. It is a compromise – not too much, not too little. If you were to use only 20 bars, you would risk entering the short-term explosive market movements which are not real trends as we have explained above. If you were to use 500 bars, you would hardly find any currency chart with trend drawdown below 20%. Before we show you how to systematically pick the best trending pairs and time frames every day, let’s look at how to use the trend drawdown in the most important aspect of trading – using a Stop Loss!
Protecting against volatility
Look at the chart above. The trader who placed the Stop Loss right after entering the market deserves great applause but the problem is, the Stop Loss is too tight! Give the market enough space to breath or the Stop Loss will be hit very quickly.
Some traders use a fixed number of pips, something like 50 pips or 100 pips…this is bad! Stop Loss has to reflect the current market volatility. Ask yourself:
“when did the price go as deep as my Stop Loss?” If it has happened several times in the current chart, why would you think your Stop Loss will not be hit now?
The ideal Stop Loss should be greater than the trend drawdown.
Listen to the market, not to the pips. In the example above, the Stop Loss should be at least 233 pips. Too much? Well, use a smaller lot size. If you trade 1 minilot and $233 is above your risk tolerance, then use microlots. Or don’t take the trade. The worst thing you can do is use a small pip value just because you want a small risk. Actually, you would risk more because if you don’t give the market enough space to breath, the Stop Loss would likely be hit regardless
of how good your trading system (or reliable the trend) is.
You would do well if you would use the trend drawdown + 1 pip as the pip value for the Stop loss (233 + 1 = 234 pips in the example). If you want to increase the success rate but on the other side, increase the risk when compared to the profit potential, your Stop Loss should be set at a much safer 1.5 x trend drawdown.
Stop Loss = 1.5 x trend drawdown = 1.5 x 233 pips = cca 350 pips
Some traders would prefer even 2 x trend drawdown = 466 pips. Such Stop Loss would be safe enough from the wild market. It’s all about statistics.
Now it’s time for a little exercise. Here are two charts with obvious up and down trends.
The maximum drawdown indicated by the blue line starts from the high at 78.66 and ends at the low at 78.18. The trend drawdown in pips is:
78.66 – 78.18 = 0.48 (48 pips)
Now let’s calculate the percentage drawdown. The visible uptrend starts from the low at 76.06 and the maximum high is at 79.50.
The overall move in the current chart is:
79.50 – 76.06 = 3.44 (344 pips
The percentage drawdown is:
48 / 344 = cca 14%
No doubt, the trend with drawdown below 15% is solid. Place the Stop Loss at least 49 pips below the initial entry point.
In the next chart, there is a downtrend.
The trend drawdown in pips is:
1.3065 – 1.2955 = 0.0110 (110 pips)
Now let’s calculate the percentage drawdown. The visible downtrend starts from the high at 1.3283 and the maximum low is at 1.2682. The overall move in the current chart is:
1.3283 – 1.2682 = 0.0601 (601 pips)
The percentage drawdown is:
110 / 601 = cca 18%
The trend reliability is moderate. Place the Stop Loss at least 111 pips above the entry point.
Whats the ultimate solution?
Discipline and patience are the two key points to succeed in the Forex market.
Stop hunting the market for every potential trade. Prepare before trading.Scanning a few currency pairs on all time frames can take you about 15 minutes, but the consequences are invaluable. Pick only the best trending currency pairs and time frames and ignore all other unpredictable movements.
Trade less, profit more. A few guidelines:
1. Trade only if the trend drawdown is below 20%,(preferably below 15%).
2. If the trend drawdown is below 15%, you can be consistently profitable even with a simple trading system such as “Donchian 5 & 20”
3. If the trend drawdown is below 10%, you have found a gold mine!You can simply enter the market in the trend direction with a 90% success rate.