AccountingChoosing a Forex Signal Provider - Examining Draw Downs
When you're looking for a third party signal provider, one of the first things that you need to look at is their maximum draw down. This is the maximum amount lost between an extreme peak and an extreme valley. This number also includes open positions but does not take into account margin required to keep you out of a margin call. Inevitably the question comes: How much draw down is too much? The answer is like many trading questions. It depends. There are a lot of factors that come into play when answering this question. Obviously a person with a 50k account could tolerate more draw down than a person with a 5k account. Another person with a 1k account could withstand even less. So aside from your account size, what else do we have to think about?
Another thing to look at aside from the actual number is how that number came to be. If a trader has a draw down that is too high for you to tolerate but otherwise seems to trade well, you should look at how many positions he opens at a time. If that trader opens 5 trades on any given pair at a time you can instantly cut their historical draw down by 5. Limiting the # of open trades for a trader could drastically reduce the overall draw down.
Sometimes you will find a trader who has a great track record aside from one major meltdown where a single trade ran out of control for days unchecked. This will produce an abnormal draw down in relation to the traders real ability. He may be the kind of guy who can't recognize when a trade has no chance of coming back to even. He may also be a guy who lost his internet connection at an inopportune time once or twice. Either way you can keep this trader from doing this to your account by setting your own stops for him. Just make sure that you only stop out his trades that are well out of a realistic trading range.
Now that we're half way down the page lets revisit our original question. After doing anything and everything you can to limit draw down, I would say that anything over 35% of your entire account equity is just too much. Once you start to get into a situation where you are losing 50% or more it is very tough to ever recover without taking extreme risks. If you lose 50% you need to make 100% just to get back to even.
When considering draw down you should also look at how much history is available on that trader. If he only has 3 weeks of history than chances are that his largest draw down is yet to come. If he has 50 or 100 weeks of history he has probably already hit some rough patches and you can get a better idea of how rough the rough patches are for that particular trader.
Also remember to constantly monitor your traders on both a live and demo account. If their draw down gets out of hand it may be time to reevaluate or completely remove that trader from your portfolio.