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My fifty cents on the subject. I think the risk of ruin is the least useful estimate for a trader. First, the definition of a ruin. For non-leveraged trading the ruin is when account goes to zero. For leveraged - when the account drops below margin. The ruin may be defined as the maximum drawdown - I will stop trading a system at 50% drawdown.
More than that, the account, drawdown and ruin are not static variables. Let's say I regularly draw money from my account. If I start with $10,000 and over the course of some time I turned it into a $25,000 and withdrew $10,000 - what is the risk of ruin? Forget for a moment about the opportunity cost, inflation etc. If we are talking about the original investment the risk of ruin is zero, as my $10,000 is stashed away. If I then run into a drawdown of $10,000 - what is it in percentage terms? 40% or 66%? If I trade 10k to 50k, remove 40k and blow the remainder, does it count as ruin?
Instead of trying to estimate the risk of ruin it is more productive to try mitigate it. Tomas Stridsman wrote once that eventually the probability of blowing the account are 100% (enough monkeys with typewriters). Therefore, removing money from risk is one way to keep it. Diversification is another. Weighing portfolio through money management is yet another. I also think that managing equity curve is another way to mitigate the risk, but this is the topic for another thread.
I have a good natured disagreement with this...to a certain extent (I mean: to the extent that I disagree, not my good naturedness)...
There are quantitative bet sizing strategies that use risk of ruin as a parameter to...mitigate risk of ruin. Which is pretty worthwhile. If you have a system with an edge, it can be helpful to know the optimal bet size that would allow you to maximize your earnings and minimize the probability of going bust. The Kelley Criterion, one such strategy that is discussed this thread, is a bet sizing system that allows a trader with an edge to maximize their edge, and at the same time it allows them to weather most conceivable drawdown situations. Consider it in this way: A trading system with an edge can still go bust. If the system is traded 'too large' then an unanticipated lengthy series of losses can bust the account. The Kelley Criterion provides a framework for bet sizing that will exploit an edge to the highest degree without jeopardizing the account during a crazy deep drawdown situation.
To your point, Individual traders without an edge probably look at ruin differently than traders with an edge. The risk of ruin calculation probably looks something like: "I should never lose x amount, or my wife will want a divorce." or "If I don't make this happen in 5 years, I'm done." Everyone has a different tolerance for ruin.
Ruin can also be defined as 'the amount of pain one must have to endure before I abandon this strategy.' Which is probably a very functional definition that a lot of individual traders grapple with all the time. Hedge funds have to consider risk of ruin because they want to make the most amount of money that they can without jeopardizing the business (I guess at least some of them have historically ).
But Risk of Ruin is an important consideration if a trading system has an edge and one wants to optimize their earnings, and protect their back side at the same time.
Here is a link to Fat Tails' risk of ruin discussion...He walks us through the ruin math and the Kelly Criterion. It's pretty good:
If by chance anyone is still following this thread, I have a question. From the Risk Adjusted Optimal F spreadsheet, can someone please explain to me what is "Point Value" (bolded red below), and in context to USD? And why does the spreadsheet example use 5 USD as Point Value?
Inital Balance 50,000 USD
Target Account 200,000 USD
Ruined Account 25,000 USD
Tolerated Risk 1.00 %
Average Win 30 Points
Average Loss 10 Points Point Value 5 USD
Percentage Win 60.0 %
Commission 0.8 Points Slippage 1 Points
Kelly Factor *) 0.25
Win Loss Ratio 3.00
Adjusted Win Loss Ratio 2.39
Optimal F 43.26 %
Risk of Ruin 0.78 %
LOL, fortunately for me I have students around the globe, and I personally support each one. So convenient times for others sometimes are early or late hours for me!
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It's not a formula, it's a probability.
You could have a low probability of ruin but still be ruined.
You could have a high probability of ruin but still make a fortune
Would there be a practical application of this approach for position sizing to trading stocks, not futures?
For example, modifying the Risk Adjusted Optimal F spreadsheet to incorporate an Entry, Stop Loss, Take Profit Price on a single trade, where the calculation of those represents the Average Win/Average Loss (per share)?
Also, I'm a bit confused as to the commission "Points" how does this translate into dollar value per trade? Is it representative of a percentage of the trade eg 1pt = 1%? And same question as to slippage, does points represent percentage?
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really good articles! I didn't know there was a risk of ruin formula and this just changed the game for me