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
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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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