The Risk of Ruin in Trading: Probability of Ruin and Loss
The risk of ruin in trading is mostly ignored by traders. Most traders are optimists, but the difference between defense and attack is often tiny. What is the risk of ruin in trading? Can the risk of ruin in trading be calculated?
The risk of ruin in trading can be calculated by using specific formulas that require some assumptions. The formulas are not perfect, but they are approximations.
The formulas provided in this article are theoretical and must be treated with caution. No formula can ever capture an uncertain future! There are many advantages to backtesting but the tests might be based on luck or being curve fitted. Besides, black swans are, per definition (negative) surprises. However, backtests are useful for approximation and understanding.
Why is it important to understand the risk of ruin?
Because ruin means financial loss. The balance between initial capital, the extent of your trading edge, and the variability of the underlying price, has been the foundation of any speculative endeavors for thousands of years. How much should you bet on each trade without facing too much risk of ruin?
What is the most important in trading?
We have repeatedly said that the most crucial thing in trading is having a trading edge. Psychology is overrated in trading – you need a statistical edge before you can think about working on your trading biases and risk management.
These are the most important things to understand in trading:
- Having a trading edge.
- Know yourself and your limit. You need a trader’s mindset.
- You need proper risk management.
Risk of ruin is all about risk management – number three on our list. Both 2 and 3 are less important than number one.
Why?
Because numbers 2 and 3 will never be able to replace a negative trading edge. Thus, you need solid, robust, and profitable trading edges before you can think about numbers 2 and 3!
That out of the way, let’s return to the subject of the article:
What is the risk of ruin in trading?
Risk of ruin is the probability or likelihood of losing all your capital or being limited from further trading. We define risk of ruin as the