Risk of ruin in trading is the probability of traders losing a significant amount of money to the point that they can no longer resume trading. Additionally, this does not equal to losing all the capitals, but it is according to personal risk tolerance which varies among traders.
While risk of ruin is highly minacious in trading, it does not only prevail in the field. Accordingly, this risk can also be recognized in investing and gambling as well.
Despite being a vital peril, numerous traders seem to possess little to minimum understanding about it. Thus, to elaborate this risk, it is wise to examine the danger and how to calculate and avoid it.
Also Read: Monte Carlo Fallacy in Trading
The Danger of Risk of Ruin
The lingering danger risk of ruin possesses is seriously threatening. The existence has caused myriad traders to enter their very own pitfall and, subsequently, brilliantly sabotage their trading.
Reflecting upon the danger, it actually does not merely terrorize traders financially. However, what is even malicious is the lack of understanding traders’ own.
The very first thing traders should do is to equip themselves with the knowledge pertinent to the jeopardy. Then, right after understanding its fundamentals, traders can attempt to combat it by calculating their risk of ruin.
Calculating the Risk to Avoid Major Losses
Perry Kaufman published a formula to calculate the risk of trading. The formula utilizes the probability of a win to calculate the risk.
The formula is: risk_of_ruin = ((1 – Edge)/(1 + Edge)) ^ Capital_Units
Edge refers to the probability of win, which will be labelled as Win% further. Win% defines as a small component of trading strategy results which belongs to the Win/Loss ratio.
To simplify the step to calculate it, Brent Penfold developed a risk of ruin simulator in Excel. The simulator, furthermore, is available for free to download through this link.
Also Read: Ways to Use Risk/Reward Ratio in Trading