Risk Of Ruin Guide And Calculator
People fail at trading for all sorts of reasons. Some people just make bad decisions regarding what to buy and sell; in other words, they excel at picking losing trades.
Other traders can’t control their emotions. They get angry when they lose. They can’t stand to lose, and eventually they get wiped out by the one trade they refused to take a manageable loss on.
I could go on and on with examples, but you get the point. There are quite a few reasons why traders fail, but one reason really stands out above the others: undercapitalization.
Simply put, people place bets that are too big for their account size, and run afoul of what is caused “risk of ruin.” This concept is a big part of understanding algorithmic trading risk management.
In this article I am going to demonstrate what risk of ruin is, why it is so dangerous and how you can calculate it for any trading strategy you have. Avoiding risk of ruin is a very important step on the road to becoming a successful trader.
Other traders can’t control their emotions. They get angry when they lose. They can’t stand to lose, and eventually they get wiped out by the one trade they refused to take a manageable loss on.
I could go on and on with examples, but you get the point. There are quite a few reasons why traders fail, but one reason really stands out above the others: undercapitalization.
Simply put, people place bets that are too big for their account size, and run afoul of what is caused “risk of ruin.” This concept is a big part of understanding algorithmic trading risk management.
In this article I am going to demonstrate what risk of ruin is, why it is so dangerous and how you can calculate it for any trading strategy you have. Avoiding risk of ruin is a very important step on the road to becoming a successful trader.
Risk Of Ruin – Coin Flip Game
Let’s start with a simple example. Suppose you and I played a coin flip game. For every flip that came up heads, you’d win $2. For every flip that came up tails, you’d lose $1. Since the coin is fair with 50% chance of heads and 50% chance of tails, it does not take much analysis for you to realize this is a REALLY good game for you to play!
If this coin flip game was a trading strategy, it would be “Holy Grail” status; it is that good. On average, for every 2 flips of the coin, you’d win $1 (first flip heads you’d win $2, second flip tails you’d lose $1, leaving you with +$1 after two flips). You'll make money in the long run, pretty much guaranteed. You merely have to stay in the game to succeed.
Of course, the flips don’t alternate heads and tails – there is random luck involved – but in the long run, say after 1000 flips, you’d likely be up close to $500. A very nice game to play!
If this coin flip game was a trading strategy, it would be “Holy Grail” status; it is that good. On average, for every 2 flips of the coin, you’d win $1 (first flip heads you’d win $2, second flip tails you’d lose $1, leaving you with +$1 after two flips). You'll make money in the long run, pretty much guaranteed. You merely have to stay in the game to succeed.
Of course, the flips don’t alternate heads and tails – there is random luck involved – but in the long run, say after 1000 flips, you’d likely be up close to $500. A very nice game to play!
At this point, you know you have a long run profitable game (or trading strategy). The question is “how much capital should you start with to play this game?”
Let’s say you start with $1 and the first flip is tails. Whoops, you lose your $1, and since that is all the money you have, you have no money to bet on the next flip. In other words, you are ruined! Game Over!
Alternatively, let’s say you start with $1,000,000. With this much capital, the chances of enough tails coming up to wipe you out is infinitesimally small (not zero, though). Your risk of ruin (getting wiped out) is really, really small.
Those are 2 extremes – very little capital, versus a great deal of capital. What about the middle? What if you had $2, or $5 or $10? Are you likely to get ruined if you start with any of those amounts?
Without doing some calculations and analysis, you just do not know. You can guess, of course, but most people would rather know up front the required amount of capital to safely play this game without risk of ruin.
For a simple coin flip like this, you could derive an answer directly using mathematical equations and probability principles. Since eventually we will progress to evaluating complicated trading strategies, I prefer to use Monte Carlo simulation to get the risk of ruin results we desire.
To help out in this analysis, I use a modified version of my Monte Carlo simulator spreadsheet for Excel, which you can freely download right here: https://kjtradingsystems.com/freemc.xls (There is a more advanced simulator available at my Calculators page.)
To run the analysis, I need a few numbers:
The Starting Equity: this is the amount I will have before I start playing the game. In other words, it is my Risk Capital. The simulator will choose different amounts, and for this case I am going to analyze with Risk Capital from $1 to $500.
The “Stop Trading” Equity: If during the simulation, my Risk Capital falls below this amount, I am “ruined.” I have lost the game and cannot place any more bets.
Number of Trades (Flips): I am going to play the flipping game 250 times. On average, if I do not get wiped out, I should gain $125.
Individual Trade Results: For this simple example, there are two outcomes with equal odds: +$2 or -$1. Those are the only possible trades.
Risk of Ruin Calculator
Once I have all those values entered in the spreadsheet, I am ready to run the Risk of Ruin Calculator. Results are given in the yellow table, as shown below:
We are interested in the columns in the red box – the starting equity (risk capital) and the Risk of Ruin.
Now, remember this is a winning game – in the long run we are practically guaranteed to win, yet if our bankroll is too small, we will LOSE. That should be an eye opener!
If you only have $1 in risk capital to play this game, you have a 61% chance of losing that dollar. And if you start with $3, you odds improve, but you still have a 22% chance of losing all $3.
But instead of a small amount of risk capital, let’s say you start with $50. With that amount of capital, your risk of ruin is effectively 0% (note it is never 0% exactly, but it is a very, very small risk of ruin).
I hope you can see the profound implications that this simple game reveals: without sufficient capital, you can get wiped out from random bad luck, even if you are playing a winning game!
Applying Risk Of Ruin To A Backtested Algo Strategy
Once you understand the basic principles behind this analysis, it is easy to apply this to actual trading strategies (that is the end goal, right?). So I’ll show you an example below.
This is the equity curve (1 contract, after slippage and commissions) of an actual strategy I trade.
This is the equity curve (1 contract, after slippage and commissions) of an actual strategy I trade.
This strategy was developed a number of years ago, so all the trades since about trade number 275 are “real time,” although the results still should be treated as hypothetical. It is a good strategy, far from perfect of course, as are most real algo strategies.
The question for this strategy is how much equity should we trade this strategy with, in order to avoid the risk of ruin?
As of today (April 2021), the required margin For Gold is $11,000. I’ll use that as the bare minimum equity to trade. If my equity falls below $11,000 I can no longer place trades – I am ruined!
When I run this strategy in the Monte Carlo simulator, here is what results:
This strategy was developed a number of years ago, so all the trades since about trade number 275 are “real time,” although the results still should be treated as hypothetical. It is a good strategy, far from perfect of course, as are most real algo strategies.
The question for this strategy is how much equity should we trade this strategy with, in order to avoid the risk of ruin?
As of today (April 2021), the required margin For Gold is $11,000. I’ll use that as the bare minimum equity to trade. If my equity falls below $11,000 I can no longer place trades – I am ruined!
When I run this strategy in the Monte Carlo simulator, here is what results:
Again, this shows if I start with a small amount of equity ($12,000) I have a very good (66%) chance of getting wiped out (falling below $11,000) by trading this system. Not too good!
But, if I have over $25,000, I am highly unlikely to be wiped out – my risk of ruin is very small, near 0%.
So, this is another example of a winning trading system, and yet I can still lose trading it. This really shows the initial capital can lead to success or failure – all because of the risk of ruin calculation.
Wrapping Up Our Risk Of Ruin Calculator Discussion
The important lesson here is that even with a winning strategy, you can still lose! And a lot of algorithmic trading risk management is staying in the game long enough to actually win. You have to be able to survive the inevitable drawdowns, financially as well as emotionally. This is where many traders make a big mistake. In their quest for a large percentage return, they will trade to close to the ragged edge, making risk of ruin a very probable outcome.
In the end, you need both a profitable strategy AND you need to trade it responsibly. Don’t let the risk of ruin scourge cause your trading failure!
About Author: Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 25 years.Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.
Kevin is the author of the highly acclaimed algorithmic trading book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.
Kevin is the author of the highly acclaimed algorithmic trading book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.