Drawdown is one of the most important terms you’ll encounter in your trading career and even in finance. Yet, with the growing popularity of prop firms over the last few years, drawdown has even become more important. It is, in fact, a very crucial factor I personally consider as a funded trader. In this article, I’ll focus on the differences between balance based and equity based drawdowns. I will also clarify why I think it’s best for you to go for balance based drawdown prop firms.
Key Takeaways
- Balance based drawdown offers static and predictable loss limits, making it ideal for low-risk strategies and traders seeking consistency.
- Equity based drawdown adjusts dynamically with floating profits and losses, providing flexibility but requiring careful monitoring to avoid breaches.
- Choosing balance-based drawdown prop firms can simplify risk management and reduce stress for funded traders.
- Effective drawdown management, including position sizing and risk reduction during losing streaks, is essential for maintaining funded accounts.
What Is Drawdown in Trading?
Drawdown is the reduction in your account balance or equity from a peak to a subsequent low. It’s actually a measure of how much you’ve lost during a series of trades before recovering or hitting new highs on your account.
Let me present a good drawdown example. Say your trading account starts with a balance of $10,000, and after a losing streak, your balance drops to $9,200. The drawdown is calculated as the difference between the peak balance and the lowest point, divided by the peak balance. In this case, the drawdown is 8%.
What is Balance Based Drawdown in Prop Firms?
As you should already know, prop firms are companies that grant you additional capital to trade on if you are able to pass their challenge. Both the challenge phase and the funded phase for almost any prop firm I’ve seen, including the big ones like FTMO and FundedNext, have a maximum drawdown limit, both overall and daily. If you lose more than your drawdown limit, you’ll lose the challenge or your funded account.
Now, when we say balance based drawdown, we’re essentially talking about how the prop firm calculates your drawdown. In balance based drawdown prop firms, your maximum loss limit is calculated with reference to your starting balance of the day or your account’s initial balance. So, they don’t consider any unrealized profits, and your drawdown limit remains static.
Now, let’s clarify things with a simple balance based drawdown example. Imagine your starting balance on the challenge is $10,000, and the daily drawdown limit is set at 5%. Your maximum allowable loss for the day would be $500. So, the limit is $9,500, and it doesn’t change even if your equity rises or falls during the day. This is an example of a balance based daily drawdown.
Moreover, balance based drawdown prop firms also calculate the overall maximum drawdown by taking your initial account balance as a reference. I mean, if your account balance reaches $10,600 after a few days, and the maximum drawdown for the challenge is 10%, you won’t lose the challenge if losses bring your account down to $9,600. Your loss limit will remain at $9,000, which is 10% below your initial account balance of $10,000.
What Is Equity Based Drawdown in Prop Firms?
Equity based drawdown prop firms have a more dynamic approach to calculating your loss limits. Equity is the sum of your account balance plus any unrealized profits or losses from open trades. So, in a nutshell, when your challenge has equity based drawdown rules, both realized and unrealized profits or losses are taken into account for calculations.
Unlike balance based drawdown, which remains static, equity based drawdown continuously adjusts based on your account’s current equity. I mean, your drawdown limit changes as your open positions move.
To break it down, let’s analyze an equity based drawdown example. Imagine your starting balance of the day is $10,000, and you open a trade that goes into $700 unrealized profit (the position is still open). So, your equity is now $10,700, and if the daily drawdown is set at 5%, your maximum loss limit for the day increases to $535 (5% of $10,700). As a result, your daily drawdown limit is no longer $9,500 (5% below your starting balance), but it’s $10,165 (5% below your peak equity), and if you go below this level, you’ll fail the challenge or lose your account.
The same calculations are true for the overall drawdown limit. Say you’ve ended your last trading day with $10,800, and you have no open position ($800 realized profits). For the next day, your overall drawdown limit will be 10% of your peak account balance ($10,800), which is $1,080. So, if your equity falls below $9,720 in the following days, you’ll lose the challenge or the funded account.
Note that in these examples, your drawdown limit is tracking and not fixed. Unlike most balance based drawdown prop firms, those with equity based drawdown limits also have a tracking maximum overall loss rule.
Balance Based Drawdown vs Equity Based Drawdown
To compare balance based drawdown vs equity based drawdown, you should understand that their main differences lie in their predictability and flexibility. Balance based drawdown prop firms use static loss limits, which are calculated on the initial balance of the challenge or funded account or the starting balance of the specific trading day.
Meanwhile, equity based drawdown calculations adjust your overall and daily loss limit based on your account’s floating profits and losses. Each method offers its own set of advantages and disadvantages, but what I can say based on my own experience is that going for balance-based prop firms is always a better choice.
Here’s a clear breakdown of their differences, pros, and cons:
| Aspect | Balance-Based Drawdown | Equity-Based Drawdown |
|---|---|---|
| Definition | Based on starting balance, doesn’t consider floating P&L. | Includes both realized and unrealized profits/losses. |
| Nature | Static, predictable. | Dynamic, fluctuates in real-time. |
| Advantages | Predictable limits make risk management simpler. | Allows traders to leverage floating profits for larger limits. |
| Disadvantages | Doesn’t account for floating equity growth. | Risky during volatile markets; floating losses can trigger breaches. |
| Best for | Low-risk, consistent strategies. | Aggressive, high-risk strategies. |
| Example | Daily drawdown limit stays fixed, e.g., 5% of $10,000 = $500. | Limit changes with equity, e.g., 5% of $10,500 = $525. |
Pro Tips for Managing Prop Firm Drawdown Rules
Managing both balance based and equity based drawdowns is critical for getting funded and keeping your funded account. So, let me present some tips based on my personal experience over the last few years of trading as a funded trader.
First and foremost, go for balance based drawdown prop firms and challenge types and relieve yourself of all the headache of equity based drawdown. As I’ve mentioned earlier, balance based drawdown prop firms have a clear and static maximum loss limit for both challenge and funded phases. This makes it predictable, and you’ll keep your mental capacity for the actual trading rather than worrying about equity calculations.
Second, remember that risk management is everything. If you want to manage prop firm drawdown, you must have a clear risk management plan. This is something most traders don’t even consider, and that’s what makes them fail. A simple rule of thumb I like is to never risk more than 1-2% on a single trade idea. Also, always set a stop-loss because you’ll never know what’ll happen.
Lastly, let me present my own strategy when I go into drawdown. Imagine I have a $10,000 account, and for my first trading day, I lose 2% on 2 trades (risk 1% per trade). After losing 2% of my account, I like to reduce my risk to half, which is 0.5% per trade idea. When my drawdown goes beyond 5%, I will reduce the risk per trade to %0.25. This strategy slows down how quickly I go into drawdown when I’m having a losing streak and gives me a chance to recover. This way, getting back to breakeven might take longer, but most prop firms don’t have a time limit these days, so why would you be in a hurry?
Conclusion
You should clearly understand prop firm drawdown rules if you want to become a funded trader. Whether it’s the static and predictable nature of balance based drawdown prop firm challenges or the dynamic structure of equity based drawdown ones, knowing how these rules work can make all the difference.
Based on my experience as a funded trader, I strongly recommend choosing balance based drawdown prop firms. Their fixed maximum loss limits allow you to focus on your trading without stressing out about tracking your equity all the time.
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