Risk of ruin is different from risk of drawdown. Ruin is usually defined as a fixed capital level, representing a large percentage loss on initial capital. For example, a risk of ruin at 45% is the probability that your initial capital falls to 55% of what you started with. As the equity grows, the risk of hitting that “ruin threshold” decreases.
Risk of drawdown, on the other hand, stays constant regardless of how high the equity grows, because the drawdown “capital barrier” keeps moving up in line with the equity.
- The two first fields (probability of win and win/loss ratio) represent the system performance characteristics. In the default example set above, the system generates 40% of winners, with winners generating on average 1.8x the size of losers.
- The third field represent the percentage of capital risked ob every trade. The risk of ruin/drawdown is highly correlated to this value.
- The “Periods” field represents the time horizon over which the simulation is run (i.e. to estimate risk of ruin/drawdown over 100 periods for example). A longer period would increase the risk of drawdowns (and potentially ruin too).
- “Loss Level” defines the level at which the drawdown or risk of ruin is set for the test (45% means that ruin/drawdown is defined as loss of 45% capital).
The risks of ruin and drawdown are estimated via a Monte-Carlo simulation and as such are not exact values. The MC process works by iterating a random process governed by characteristics such as probability of win, payoff ratio, percentage of capital risked on each trade. With the default input values, the risk of drawdown is defined at around 25%. This means that with the given system (prob. win = 40% and win/loss ratio = 1.8), the risk of reaching a drawdown of 45% over 100 periods is around 25% when risking 4% capital per trade.
The tool is useful to check that decreasing risk per trade to 3% reduces the chance of drawdown to around 9%. On the other hand, increasing risk per trade to 5% increases the chance of drawdown to around 45%. The risk of drawdown also increases with number of periods tested (ultimately, risk of drawdown tends to 100% for any system). Doubling the number of periods to 200 for the default values increases the chance of 45% drawdown to around 52%.