Risk of Ruin

Risk of ruin is the probability that a trader loses enough of their account to be effectively out of the game, either losing everything or falling below a level they cannot recover from. It depends on three things: your edge (expectancy), how variable your results are, and how much you risk per trade. The striking lesson from risk of ruin is that even a profitable strategy can wipe out an account if each trade risks too much.

What drives risk of ruin#

Of these, risk per trade is the one you control directly every day.

A simulation#

The table below comes from a Monte Carlo simulation we ran of a strategy that wins 45% of the time, with wins of 1.5R and losses of 1R. Its expectancy is a positive +0.125R per trade. Each simulated trader took 500 trades, risking a fixed percentage of their current account each time. "Ruin" here means a 50% drawdown from the starting balance.

The same profitable strategy goes from almost no chance of a disastrous drawdown at 1% risk to worse than a coin flip at 10% risk. Nothing about the strategy changed; only the size of each bet. See Monte Carlo Simulation.

Ruin is often psychological before it is financial#

Many traders quit, or abandon their plan, long before reaching zero. A 30% or 40% drawdown is enough for most people to stop following their rules, start revenge trading or give up. For practical purposes, define ruin as the drawdown at which you would stop trading the strategy, and size to make that very unlikely. See Maximum Drawdown and Revenge Trading.

How to keep risk of ruin low#

1. Have a positive expectancy after costs. Without an edge, ruin is only a matter of time. See Expectancy.
2. Risk a small percentage per trade, usually 0.5% to 2%. See Position Sizing.
3. Use fixed percentage sizing, so position size shrinks during drawdowns. See Fixed Percentage vs Fixed Dollar Risk.
4. Limit correlated exposure, since correlated losses act like one larger bet. See Portfolio Heat.
5. Never bet more than the Kelly fraction; ideally use a fraction of it. See Fractional Kelly.
6. Simulate your own strategy with your actual win rate and payoff to see the range of drawdowns you might face.

Classic formulas and their limits#

Simple risk of ruin formulas exist for fixed bet games, such as the gambler's ruin problem, and approximations for trading based on win rate, payoff ratio and units of capital. They are useful for intuition but assume fixed bet sizes and independent trades. Simulation with your own trade results is usually more realistic. See Monte Carlo Simulation.

Common mistakes#

• Assuming a profitable strategy cannot ruin you.
• Sizing up after a winning streak, right before an inevitable losing streak.
• Defining ruin as zero when the real breaking point is much earlier.

Frequently asked questions#

What is risk of ruin in trading?#

The probability of losing enough capital to be unable to continue trading, either everything or a set drawdown level.

Can a profitable strategy still blow up an account?#

Yes. With too much risk per trade, normal losing streaks can cause catastrophic drawdowns even when the strategy has a positive edge.

How much should I risk to avoid ruin?#

Most traders keep risk per trade between 0.5% and 2%. Simulating your own strategy's results gives a more precise answer.

Next, learn how long streaks can get in Losing and Winning Streaks.