V.10:12 (525-528): Appreciating The Risk Of Ruin by Nauzer J. Balsara

V.10:12 (525-528): Appreciating The Risk Of Ruin by Nauzer J. Balsara
Item# \V10\C12\APPRECI.PDF
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Appreciating The Risk Of Ruin by Nauzer J. Balsara

Traders focus on developing trading rules and systems that identify market entry and exit points. A factor that is often overlooked is the percentage of trading capital available that is risked on trades. This article analyzes the risk of ruin by varying three parameters using a Monte Carlo simulation. The results can help you determine your chances of success.

A trader is said to be ruined if his or her available capital falls below the minimum required to trade. The risk of ruin is a probability estimate ranging between zero and 1. A probability estimate of 0 suggests that ruin is impossible, whereas an estimate of 1 implies that ruin is assured. The risk of ruin is a function of:

• The probability of success

• The payoff ratio, or the ratio of the average win to the average loss on completed trades

• The fraction of capital exposed to trading.

In its most elementary form, the formula for computing the risk of ruin as defined by statistician William Feller makes two simplifying assumptions: that the payoff ratio is 1 and that the entire capital in the account is risked to trading.




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