Risk of ruin

You can explain risk of ruin, show how risk per trade drives it even for a positive rule and define your own ruin level.

A good rule, a ruined account

Imagine a trading rule that makes money on average. Over hundreds of trades, it comes out ahead. It sounds like the hard part is done.

It is not. The same rule can still destroy an account, not because the rule is bad, but because of how much each trade risks. This lesson is about the one risk that ends everything else: not being able to continue.

Survive to reach the long run

Risk of ruin is the probability of losing so much that you can no longer continue trading. Ruin does not have to mean zero. For most people, it comes earlier:

Financial ruin. The account is too small to trade sensibly, or a margin call closes everything.
Practical ruin. The drawdown is so deep that recovering would take years, as the drawdown maths showed.
Psychological ruin. The trader gives up the rule, or starts gambling to win it back.

Expected value, as the psychology chapter showed, describes the long run: the average over many trades. But the long run is only reached if no losing streak along the way knocks you out. A rule with a positive expected value and a large risk per trade is like walking along a cliff with long strides. On average you move forward, but one bad sequence is enough.

The main levers on risk of ruin are:

Risk per trade. By far the biggest lever. Smaller risk means a streak takes away less.
Win rate and payoff. A rule that wins rarely, with large wins, has longer losing streaks.
Your ruin level. A trader who stops at −30% has a stricter limit than one who stops at −90%.

There are formulas that estimate risk of ruin for simple rules, and simulations that test many random orders of the same trades. Both show the same thing: as risk per trade rises, risk of ruin rises steeply, long before the risk looks reckless on a single trade.

Same trades, three fates

A fictional rule wins 30% of the time with +3R and loses 70% of the time with −1R. Its expected value is +0.2R per trade. Here are 20 of its trades, including a streak of ten losses, starting from 10,000.

2% per trade: the streak costs about 18%. The account ends at about 10,690.
10% per trade: the streak costs about 65%. The account recovers to about 11,040, but only after falling from roughly 15,200 to 5,300.
25% per trade: the account first climbs to about 23,000, then the streak takes it to about 1,300, a fall of 94%.

Even where an account ends higher, a fall of 65% or more is practical ruin for most traders. They stop, change the rule or raise the risk long before the recovery.

Common mistakes

"The rule is positive, so I can't lose." You can, if a streak comes before the wins.
Defining ruin as zero. Set your own limit, for example −30%, and plan to stay far from it.
Judging risk on one trade. 10% sounds manageable once. Ten times in a row, it is not.
Testing only one order of trades. The same trades in a different order can produce a much deeper drawdown.

The takeaway

Risk of ruin is the chance of losing so much that you can't go on. Even a positive rule can ruin you when each trade risks too much.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the account that came closest to ruin.

Tap the chart.

Risking 25% per trade, ten losses in a row left about 6% of the peak. Few traders could, or would, continue from there.
2What drives the risk of ruin most for a given trading rule?

The same rule with the same trades survives at small risk and can be wiped out at large risk.
3Ten losses in a row at 10% risk per trade. Roughly what is left of the account?

0.9 to the power of 10 is about 0.35, so about 35% is left, a drawdown of about 65%.
4Why can a rule with positive expected value still lead to ruin?

Expected value describes the long run. You only reach the long run if no streak along the way ends your trading.

of 4 correct.

Sources

Back to Risk & Money Management