Risk Of Ruin / Risk Of Drawdown Calculator

 

Use the following calculator to determine your long term trading risks:

% Chance Of Drawdown: 0%

% Chance Of Retirement: 100%

Notes:

  • The tool assumes that all profits and losses are compounded after every trade.
  • While technically the risk of ruin is always zero when compounding, when calculating the probability of ruin this tool will give the probability of virtually reaching ruin.
  • This tool looks up the results from a database that was compiled using extensive simulated trading algorithms (over 370 million simulations, over 10 trillion trades)

If you have any questions or comments about this calculator, please contact us to let us know.

We recommend you bookmark this page to refer back to the calculator as you develop your trading strategies.

 

Explanation of input variables into the risk of ruin / drawdown calculator:

% Winners: What percent of your trades are winning trades?

Reward:risk: This is the ratio of average gain to the average loss

Risk / trade: What percent of your current account balance do you risk per trade? The risk taken is a constant percent of the current account balance, so profits and losses are compounded over time.

Drawdown tolerance: What percent of your account balance can you tolerate losing before you give up and quit trading, or at least quit your current trading system? For most people this is much less than 100%.

Retirement target: How much do you need to multiply your account by before permanently taking profits off the table? Alternatively, this is whatever target gain you are shooting for, to make the risk you are taking worthwhile. 

Number of trades: How many trades should the simulator run? The more trades you make, the greater the chance that you will hit a boundary, whether that be the drawdown limit, or the retirement target.

 

What makes this risk of ruin / drawdown calculator better than others:

Drawdown: Most of these types of calculators only tell you the risk of ruin, of losing your entire account balance. This is not very useful because most traders will (or should) stop trading well before that happens and re-evaluate their trading system. In the stock market a buy and hold trader can be confident the market will come back and make him money after a large drawdown. However, in forex trading or any other kind of trading there is no reason to think that your performance will rebound after a big drawdown. For this reason a trader should have a lower tolerance for drawdowns than they do for the stock market. It is important then to determine what your risk tolerance is, and then use our tool to calculate the probability of reaching that point.

Number of trades: a lot of risk of ruin calculators just use a formula to calculate the probability of ruin. This does not give accurate results because it ignores the number of trades. It should be obvious that if you risk 1% of your account per trade, and you make 50 trades, that your probability of ruin is zero, regardless of your % winners. However, the risk of ruin tools that are based on a formula do not say it is zero. The reality is that if you compound your performance, as you increase the number of trades, you increase the probability of a losing streak that will essentially wipe out your account. Technically, if you were to compound your trading performance while trading for an infinite duration, there is 100% chance that your account would hit a losing streak that would draw your account down to a level infinitely close to zero. Our tool factors the number of trades into the calculation by having actually simulated the number of trades specified. It will show that the probability of hitting your drawdown tolerance is always the same or higher as you increase the number of trades.

Retirement target: if you are compounding your gains and losses over time, you may become profitable enough so that your account size grows to be much larger than your opening account balance. At this point, you may want to consider taking profits off the table so that they are no longer at risk. This tool lets you choose such a target, so that you can determine the probability of hitting that target and compare it to the probability of instead hitting your drawdown limit. Needless to say you will want your probability of hitting the target to be much higher than the probability of reaching your drawdown tolerance. In using this feature, this calculator will produce lower risk of ruin than other calculators. Using this strategy in real life significantly decreases your risk of ruination. 

Monte Carlo simulation: We have built up a database of probabilities by actually simulating trade performance with the different combinations of inputs noted above. The combinations available represent over 37,000 different scenarios. Each scenario was simulated over 10,000 times to calculate the probabilities with the highest accuracy. This means that over 370 million simulations making over 10 trillion trades were run to build this database of trade risk and performance.

 

Insight and analysis from the risk of ruin / drawdown tool:

There are several insights that can be gained from using this tool. Some are obvious and some are less obvious. 

Some of the obvious insights are that risk of ruin or drawdown will increase if:

1) risk/trade increases. If you risk more per trade, you need less losing trades before your account is ruined, or drawn down.

2) win % decreases. This decreases your expected profit per trade, eroding your "edge".

3) drawdown tolerance decreases. You are more likely to hit a tolerance limit if you make the tolerance tighter, allowing less room for performance variability.

4) retirement target increases. If you make it harder to hit your retirement target, you are less likely to hit that target, and thus increase your downside exposure. Conversely, taking profit off the table after growing your account is one of the most effective ways of managing your long term trading risk.

 

The following are less obvious insights, that a formula based calculator may miss:

5) Your risk of ruin increases as your number of trades increase, everything else being equal. This makes intuitive sense if you consider a casino roulette wheel analogy. You are less likely to go broke betting on black if you only bet 10 times and then leave the casino, compared to if you bet 10,000 times. More trades gives more opportunities to get a large losing streak that will drawdown your account or wipe you out. The following chart illustrates real data from our risk calculator for two different simulated scenarios. Each scenario has the following characteristics:

Scenario 1: 60% wins, 1:1 reward:risk ratio 

Scenario 2: 40% wins, 2:1 reward:risk ratio

In common: 30% drawdown tolerance, 3% risked per trade, 1000x retirement target, 0.6% expected profit / trade.

Chart showing risk of drawdown vs the number of trades

 

6) Trading system "A" with low Reward:Risk and high win % is more robust than system "B" high Reward:Risk and low win %, even if both have the same profit per trade. To explain this one, we will proceed in a series of steps. The first step shows a straightforward chart showing how risk of ruin / drawdown increases as risk/trade increases:

Chart showing risk of drawdown vs risk per trade

The above chart was created for system "A", which has a 1:1 reward:risk ratio and a 60% win rate. This means that expected profit per trade is 20% of the money risked. Now let's add the following two systems to the chart:

  • system "B" has a 2:1 reward:risk ratio and a 40% win rate. The expected profit per trade is still 20% of the money risked.
  • system "C" has a 3:1 reward:risk ratio and a 30% win rate. The expected profit per trade is still 20% of the money risked.

Adding these two additional trading systems to the chart looks like this:

Charts showing risk of ruin / drawdown for trading systems with the same expected profit per trade but different win % and R:R ratios

As you can see, even though all three trading systems have the same expected profit/trade, they have very different risk profiles. Those systems with higher R:R and low win % have much higher risk of hitting the drawdown limit compared to the systems with lower R:R and higher win %. This makes intuitive sense, because a system that loses most of the time is much more likely to get a string of many losses to draw down the account. Put another way, the systems with lower R:R and higher win % allow for higher risk / trade for the same drawdown risk. The end result is that these systems are either lower risk, more profitable, or a mix of both.

You may be tempted to say "just go with high R:R trading systems, but get a higher win %". Of course this is tempting, but not realistic. Most markets, especially forex markets are very big, liquid and efficient. The resulting efficiencies simply don't allow for high win % with high R:R ratios. It may be achievable in the very short term, but will never be sustained in the long term. 

One of the most important lessons in using this risk of ruin / drawdown tool is to pursue trading systems with low reward:risk and high win %. A more detailed analysis of this phenomena can be found in Modeling Trading System Performance by Howard Bandy.

 

If you have any questions or comments about this calculator, please contact us to let us know.

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