THE HAnDbook of TECHnICAl AnAlysIsarbitrary. There are many formulas available to calculate the risk of ruin based on
R/r ratios, percent risk per trade (%risk), and average historical win percentage.
Risk of ruin may be estimated using:
■ (^) Probabilistic formulas
■ (^) Hypothetical random tests via Monte Carlo simulations
■ (^) Empirical data from backtesting
Below are two important facts that are obvious from Monte Carlo simulation
studies:
- There is evidence that the probability of profitability increases as the number
of trading units or trading opportunities increases in the system. This means
that we should trade using a smaller percentage risk per trade. - It shows that greater asymmetric leverage within the system requires a higher
number of trade units in order to remain profitable, that is, to maintain posi-
tive expectancy (which is not accounted for in most of the ROR formulas).
Although many risk of ruin formulas attempt to indicate the chance of experienc-
ing catastrophic loss, it can be somewhat misleading. This is because such formulas
do not account for many of the idiosyncrasies and anomalies associated with trading.
Hypothetical trade simulation provides a more reliable gauge of the risk of ruin.
Capital sizing
It is extremely important to be well capitalized in order to increase the probability
of longer‐term survivability in trading. Greater amounts of capital allow for more
trade units or opportunities, giving the system a chance to recover to profitability.
It also allows the trader to participate in certain markets or systems with the
greatest chance of surviving large drawdowns.
Let us look at one simple example of how ineffective capital sizing may impact
a trader adversely. In Figure 28.14, we are given a balance curve of some trading
figure 28.14 Balance Curve of a Hypothetical Trading System.