The article discusses how "The Risk of Ruin" is calculated in foregn Exchange trading.
|The Importance of using the Risk of Ruin Calculation in Trading
Money management is a critical component in foreign exchange trading. When developing a system, one should always calculate the Risk of Ruin of a trading system.
Some forex brokers accept very small accounts and make incredible promises in what can be achieved in that scenario. But, unless one is "just practicing" and using micro pips, one should not have any positive expectations on results.
The Risk of Ruin is the probability that a trading stake will go bust, given a dollar equivalent standard deviation, a winner:loser ratio and a dollar trading stake. The calculation utilizes the natural log and the result is a percentage probability.
I developed a trading system utilizing Bollinger Bands and created two realistic scenarios given different trading stakes. Bollinger Bands are placed two standard deviations away from the "mean" price over time. That is, assumed is that markets are mean-reverting. When the market deviates above or below two standard deviations,from its average, it will revert back to it's average price
The system I created has a "spread" in pips of two and has a trailing stop of $200.00. That is, the cost of entry and exit is two pips on either side. Basically the system enters the market when the last price exceeds two standard deviations on the up or downside, It enters will a sell-stop on the upside and a buy-stop on the downside. And by using a trailing stop, trades are exited when losses exceed $200 on any given trade. I used EUR/USD from 3-21-2005 to 3-21-2007.
First, I used a trading stake of $1000, the accounts "bust" within just three trades.In the second scenario, I started out with the same values, but quadrupled the trading stake to $4,000. What is the Risk of Ruin?
With a win rate of 28.5%, a dollar standard deviation rate of $1876, one can calculate the Risk of Ruin as follows:
Risk of Ruin = e^(-2 x WR x ST ÷ (SD x SD))
e = Constant (2.718281828)
WR = Win Rate
SD = Standard Deviation
ST = Stake This shows that over two years, our probability of going broke on the account is 94%
But what happens when the account is at $20,000 ? The Risk of Ruin is now reduced to 72%. While an unacceptable ratio for actual trading, it can be shown that using inadequate amounts of capital in trading increases the probability of losing the entire trading stake.
Don't trade forex unless you can afford it.