Balance-Based Drawdown and Equity-Based Drawdown are two distinct methods for managing risk in trading. They differ in how they consider your trading account balance and when they trigger your loss limit.
Balance-Based Drawdown: Regarding the balanced-based drawdown, it means that the drawdown is calculated based on the initial balance of the trading account. For example, if you have an account of $100,000, the drawdowns will be calculated on the initial balance, which is $100,000.
Equity-Based Drawdown: This method considers your current account balance, including any profits you've earned or potential losses you might incur in real time. It's like constantly checking your trading account every time you earn or loss any trades throughout the day.
In simpler terms, Balance-Based Drawdown is like a snapshot at the start and end of the day, while Equity-Based Drawdown is continuously updated.
To make these concepts clearer, let's explore them through three scenarios:
Scenario 1: You have a trading account with $100,000 and a daily loss limit of 5% of your account size, which is $5,000. During the day, your open trades are running or floating at a loss of $5,000.
Balance-Based Drawdown: With the Balance-Based Drawdown method, it's like having a daily budget of $5,000 in your account when you start your trading day. Now, your open trades start showing a loss of $5,000 during the day. The moment your trades reflect this $5,000 loss, you've reached your Daily Loss Limit. With this method, you can't afford to lose more money for the day. It's similar to having a fixed loss limit for the day, and as soon as your trading losses reach that loss limit, it will be considered as a violation of the daily drawdown.
Equity-Based Drawdown: Equity-Based Drawdown operates differently. It treats your account balance as a balance that keeps changing, updating each time you make a profit or suffer a loss. At the beginning of the day, you had $100,000 in your account. As your open trades accumulate a $5,000 loss, your account balance drops to $95,000. With Equity-Based Drawdown, it doesn't wait until your losses exceed your initial daily loss limit. Instead, it checks your account balance in real-time. The moment your trades reflect this $5,000 loss your daily loss limit touches and you can't spend more for the rest of the day.
Conclusion: In this scenario, both the Balance-Based and Equity-Based methods lead to the same outcome. The trader reaches the Daily Loss Limit immediately upon facing a floating loss of $5,000
Scenario 2: You have a trading account with $100,000 and a daily loss limit of 5% of your account size, which is $5,000. You begin the day with a $100,000 trading account balance. During the day, you make a profit of $1,000. At the same time, you have some trades that are running into a $5,000 floating loss.
Balance-Based Drawdown: You have a $100,000 account, the maximum daily loss limit is $5,000, and you have gained $1,000 in profit on that day. In such case, you will be allowed to lose $1,000 (your profit) + $5,000 (your daily loss limit) = $6,000 for that day only. The next day your daily loss limit will reset and will be calculated on the initial balance which is $100k. So, on that day even if you lose $5,000 you will still have a $1,000 permitted loss.
Equity-Based Drawdown: Equity-Based Drawdown operates differently. It treats your account balance as a balance that keeps changing, and updating each time you make a profit or suffer a loss. You started the day with $100,000 in your account. As you make a $1,000 profit, your account now holds $101,000. However, you also have those potential expenses (the $5,000 loss) looming. Here, your equity-based drawdown is approximately 4.95% ($101,000-$5,000), which is just under your daily loss limit of 5%. This means that, even though you have some losing trades, you haven't yet reached your daily loss limit, thanks to the profit you made on other trades.
Conclusion: The crucial difference here is how these methods handle your account balance. Balance-Based Drawdown sticks to the original account balance until the end of the day, while Equity-Based Drawdown keeps your account balance updated throughout the day. This real-time monitoring can impact you when you reach your Daily Loss Limit, affecting your trading decisions based on your current financial situation.
Scenario 3: You have a trading account with $100,000 and a daily loss limit of 5% of your account size, which is $5,000. But yesterday, you made a loss of $1,000. Now, you started a new day with $99,000 in your trading account.
Balance-Based Drawdown: This method gives you a fresh start every day, no matter what happened yesterday. It doesn't matter if you lost money yesterday because today is a new day. You can lose up to $5,000 today before hitting the Daily Loss Limit.
Equity-Based Drawdown: Equity-Based Drawdown remembers yesterday's loss. So, because you're starting the day with $99,000 (after subtracting yesterday's loss), your Daily Loss Limit for today is $4,950.
Conclusion: Again, the Balance-Based Drawdown method provides a bit more wiggle room before reaching the Daily Loss Limit. It disregards previous losses and allows traders a fresh start each day, providing flexibility to manage positions. In contrast, Equity-Based Drawdown considers previous losses when calculating the Daily Loss Limit, which can constrain trading activities based on past performance.
From the above scenarios, it is evident that the Balance-Based Drawdown is better for trading compared to Equity-Based Drawdown. At FundedNext, the drawdown is calculated as Balanced-Based Drawdown.