The Risk of Ruin
Some calculations
On page 66 of
Smarter Trading, Perry Kaufman
discusses the risk of ruin and
provides us with a formula to work with. He considers the following
2 premises:
-
In real trading, once profits accumulate, the chance of ruin
decreases. The greatest risk is at the beginning.
-
If we plan to withdraw profits, thereby maintaining the same
relative commitment to the market then the risk of ruin must be
greater than if we accumulate profits and keep the trading position
the same.
Kaufman gives us the following formula for calculating the risk
of ruin:
risk_of_ruin = ((1 - Edge)/(1 + Edge)) ^ Capital_Units
Edge is the probability of a win.
We can see that the mechanics of the formula are such that the
larger the value of Edge the lower will be the risk of ruin. This
is also intuitively logical because the greater your edge in any
strategy the more likely you will have more winning trades. Also,
the greater the number of capital units employed the lower the risk
of ruin. Again this should be obvious: The smaller the amount you
risk for any one trade relative to your capital base the lower the
risk of ruin.
Why is risk greatest at the beginning? (added 11 July
2005)
As mentioned above, the risk of ruin is greatest at the
beginning.
One reason is because your capital base is smallest at this
point and if you immediately hit a string of losses it will take a
smaller string of losses to wipe out your account - this is
discussed in detail below in
Our Example.
There is another reason why risk
might be greatest at the beginning. This may be because of
lack of experience. An experienced trader who has survived for a
long time will have overcome losing habits that a new trader may
still have. These losses may be from simple things such as not
operating the trading platform correctly to more complex
discretionary decisions about when to override the system.
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