By Taro Hideyoshi – The term Risk of Ruin in trading refers to the probability of losing entire trading account because of a string of losses.
For example if you are trading a futures contract, when you go long or sell the chances that the prices will move in the same direction as your opened positions is 50 percent. The odds indicate that if you trade ten times, you most likely will get five losses and five wins.
If your capital in trading account is $1000, what is the size of risk you would allow for each position? If you decide that you will get out of the position when you lose $100 which is ten percent of your account size. This means you will wipe out your account if you lose ten times in a row from the beginning.
What is the probability that you will lose ten times in a row? It is mostly impossible. But the problem is you still have chance of losing. As a matter of fact, I experienced this myself.
I thought that it was not possible for me to lose more than five times in a row. Since I technically analyzed the price movement by using charts and indicators, this should give me an edge to win a trade. I thought I have better than 50 percent chances to win. According to the Kaufman’s formula for calculating the risk of ruin as follow:
Risk of Ruin = ((1 – Edge) / (1 + Edge)) ^ Capital Units
Even though I had a period that the trades were in my favor, I won the trades many times in a row. My account continued to grow up but eventually, I faced the string of losses until my account was wiped out.
No one never lose even the greatest traders in the world, the most important aspect is you need the ability to stay in market. If you are wiped out from the market, you have no chance to win.
Taro is an experience trader who trades in stocks, futures, forex. He strongly focuses on technical analysis, trading systems and money management.
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