{"id":215,"date":"2015-04-19T15:25:49","date_gmt":"2015-04-19T05:25:49","guid":{"rendered":"http:\/\/li209-143.members.linode.com\/?p=215"},"modified":"2022-10-24T13:32:33","modified_gmt":"2022-10-24T03:32:33","slug":"riskofruin","status":"publish","type":"post","link":"https:\/\/bettersystemtrader.com\/riskofruin\/","title":{"rendered":"Do you know your Risk of Ruin?"},"content":{"rendered":"
Trading is a risky business and so many people who enter the trading world fail, losing large amounts of money in the process.<\/p>\n
Have you already lost a large sum of money or are you on the path to becoming another trading statistic? How do you know?<\/p>\n
Brent Penfold from IndexTrader.com.au, who has been trading successfully since the 1980\u2019s and was a guest in Episode 2 of the Better System Trader podcast here<\/a>, believes \u201cwhy people lose is essentially most people are clueless about this key concept, Risk of Ruin.”<\/p>\n Are you currently trading a system with money management that is destined to fail? To find out, you need to calculate your Risk of Ruin and we’re going to show you how.<\/p>\n Risk of ruin is the probability that you\u2019ll lose so much money you can no longer continue trading. This doesn\u2019t mean losing all of your trading capital, the ruin point is based on your own personal risk tolerance, so ruin to you could be 15%, it could be 50% or it could be 100%.<\/p>\n Click To Tweet<\/a><\/p>\n The risk of ruin formula published by Perry Kaufman and discussed here<\/a> and here<\/a> uses the probability of a win to calculate the risk of ruin:<\/p>\n risk_of_ruin = ((1 – Edge)\/(1 + Edge)) ^ Capital_Units<\/p>\n Edge is the probability of a win or the Win%.<\/p>\n Win% is only one small component of strategy performance results and really needs to be considered along with the Win\/Loss ratio, or the size of the wins compared to the size of the losses, to give a true indication of how a strategy performs. There are many profitable trading systems that have a win% as low as 30% but the size of the wins are many times larger than the size of the losses so the strategy is still profitable over the long term.<\/p>\n Including the Win\/Loss ratio in the Risk of Ruin calculation makes the formula much more complicated so Brent Penfold from Indextrader.com.au has kindly provided the Risk of Ruin simulator he\u2019s developed in Excel as a free download to Better System Trader podcast listeners. There is a link to download the simulator at the end of the article but let\u2019s run through it first to see how it works and how we can apply the results to our own trading.<\/p>\n Click To Tweet<\/a><\/p>\n When you open the simulator, there are a few values you need to enter based on your trading strategy. (If it prompts you to enable the macros you will need to say yes otherwise the simulator won\u2019t work).<\/p>\n In this example I’ve entered the values for a trend following strategy:<\/p>\n <\/a><\/p>\n Push the \u2018Simulate Risk of Ruin\u201d button and the simulator will make a single run of trades based on your Win% and Win\/Loss ratio until it reaches either the % Drawdown limit or the equity curve reaches 10,000 trades or $200 million, in which case it is assumed Ruin has been avoided. Immediately we can see with Accuracy of 41% and a Win\/Loss ratio of 1.95 the Expectancy is 21% so the system itself has a positive expectancy but the Risk of Ruin is 76%. Keep in mind this is only a single run, so I\u2019ve run 30 simulations and we see the results can often be worse with some runs producing a 100% Risk of Ruin:<\/p>\n <\/a><\/p>\n The average Risk of Ruin over 30 simulations was 85% which is a guarantee we will meet the ruin point of 35% drawdown at some stage in the future.<\/p>\n Click To Tweet<\/a><\/p>\n There are 3 ways to reduce Risk of Ruin without adjusting the Drawdown level:<\/p>\n I\u2019m actually happy with the Win% and Win\/Loss ratio of this strategy so let’s investigate money management as a way to reduce the Risk of Ruin. We’re currently risking 4% of trading capital on each trade, let\u2019s see how the risk of ruin changes if we reduce the risk to 2% per trade:<\/p>\n <\/a><\/p>\n Risk of Ruin has now been reduced to 0% in this simulation but we can never know the order of trades that will occur in the future so we need to run multiple simulations, here are the results after 30 runs:<\/p>\n <\/a><\/p>\n We can see that some simulations produced a Risk of Ruin of 0% but other runs had a Risk of Ruin of 70 \u2013 80+% so the average over 30 runs was 54%. This is still too high because we can never know the order of trades we will experience in the future, we may get the run with 0% Risk or Ruin or we may get the run of trades with 86% Risk of Ruin.<\/p>\n Let\u2019s try reducing the risk to 1% per trade.<\/p>\nWhat is Risk of Ruin?<\/h3>\n
Calculating your own Risk of Ruin<\/h3>\n
Using the free Risk of Ruin simulator<\/h3>\n
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\n<\/a><\/p>\nReducing your Risk of Ruin<\/h3>\n
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