Risk of ruin as a pre-entry position filter

Expected return is not a sufficient reason

Risk of ruin is an estimate, from 0% to 100%, of the chance that trading capital is eventually exhausted. It is used as a filter that bounds loss or exposure before a trade is placed and while it remains open.

The trade with the highest expected return under a price-probability forecast is frequently not the trade to recommend once other factors are included. A potentially large payoff can still be unsuitable when the dollar risk is weighed against win and loss probabilities and the trader's total capital.

Expected return is the average payoff implied by forecast prices and probabilities. It is not by itself a sufficient reason to take the trade.

Consecutive losses can exhaust trading capital

The construction problem is not only one unbearable single-trade loss, but also the chance that several consecutive losses occur. Consecutive losses are a run of losing outcomes that can wipe out an account even when the setup itself is favorable.

Position stake is the dollar amount placed at risk on one trade. It should be set with the most pessimistic long-term outcome in view, and sized so the most pessimistic long-term sequence still leaves the account intact.

A favorable game can still run out of units

In a 50% coin-toss example that pays 1.50 on a win and costs 1.00 on a loss, three or more losses in a row can still appear within about a dozen trials.

Starting the same favorable game with 20 units can look acceptable, while starting with 3 or 4 units can make play unwise because capital may be exhausted before it can grow.

Four inputs set the ruin estimate

The estimate is determined from four inputs: the profit objective, the stop-loss, the win probability, and the trading capital.

Profit objective is the planned dollar gain if the trade finishes as a win. Stop-loss is the planned dollar loss if the trade finishes as a loss. Win probability is the chance that a trade ends as a win rather than a loss. Trading capital is the account equity available to absorb losses, and the stock against which a single-trade stake is judged.

Risk of ruin estimates the probability, from 0% to 100%, that a trader eventually loses all trading capital. Keeping risk of ruin as low as possible, such as near 1%, is presented as a desirable construction target.

The estimate bounds the position before entry

Used this way, the finished estimate is a filter that bounds loss or exposure before a trade is placed and while it remains open. The position stake is judged against trading capital so a realistic run of consecutive losses does not exhaust the account first.