Drawdown is the reduction in your trading account’s balance or equity, including the profit or loss of both running (floating) and closed trades. There are two common types of drawdowns in the Prop evaluation industry:
Balance-Based Drawdown
Equity-Based Drawdown
While both ultimately calculate drawdown, there are some slight differences between Balance-Based and Equity-Based Drawdown. Let’s dive into these topics to understand how they work.
To make these concepts clearer, let's explore them through three scenarios:
Balance-Based Drawdown
Balance-Based Drawdown is set based on the account’s initial balance. This means if your starting account size is $6,000 and your daily drawdown limit is 5%, your daily drawdown amount is $300.
This is static—this $300 amount will not change even if your account profits increase or your balance drops below the initial account size.
In other words: If your account starts at $6,000 and you make a $200 profit, bringing your balance to $6,200, your daily loss limit will increase for that day. By the end of the day, before the reset at midnight, you can lose a total of -$499 allowable loss for the day.
When the PnL is calculated, the process is as follows: subtract your total loss (-$499.99) from your profit for the day ($200), which results in a negative value (-$299.99). This means you could lose up to $299 before hitting your daily drawdown limit. Once the loss reaches -$300, the account will be breached.
If you lose $200, bringing your balance down to $5,800, the drawdown limit for the following day will still be based on your initial balance of $6,000 and will not decrease. It remains consistent, even if your account size fluctuates during the day.
Regardless of whether the loss is floating or closed, as the basic definition of Drawdown suggests, the loss will be counted. Even unrealized losses on open trades (floating losses) will be counted toward this drawdown, meaning you could breach your daily limit without closing a trade.
Equity-Based Drawdown
Equity-Based Drawdown considers all sorts of equity drops in your account, meaning even a drop from being in a $300 profit to $200 will account for a $100 loss. Let’s see how the drawdown works when it is based on the start or end-of-day equity:
The drawdown is calculated based on your start or end-of-day equity, including floating profits or losses.
Example:
At the start or end of the day (00:00 GMT+2), you have two trades running with a total PnL of +$200 in your $6,000 account. So, your start or end-of-day equity is $6,200, based on which the 5% loss limit will be calculated. The daily loss limit is $310, which seems better than Balance-Based Drawdown, right? But to evaluate this fully, we need to understand how drawdown is calculated in Equity-Based Drawdown.
Let’s return to the example where your equity is $6,200, and the daily loss limit is $310. The next day, the two running trades’ PnL increases to +$500 but later decreases to +$150.
According to the Equity-Based Drawdown calculation, you have lost $350, which breaches the daily loss limit of $310 that was set based on the start or end-of-day equity of your account.
This means that even though the loss is unrealized (as you haven’t closed the trade), the drop in floating profit is counted, which can lead to a breach of the drawdown limit without having closed any positions.
Conclusion
Now we can see how Balance-Based Drawdown differs from Equity-Based Drawdown. While Balance-Based Drawdown offers more consistency and predictability since the daily loss limit is based on the initial account balance, Equity-Based Drawdown is more dynamic because it adjusts based on the current equity, including floating profits and losses.
Traders who manage floating positions closely may prefer equity-based limits as they adjust based on the latest equity value. However, balance-based limits might suit traders who prefer a fixed daily limit and don’t want to worry about floating PnL fluctuations affecting their drawdown. The choice depends on your trading strategy and risk tolerance.