Drawdown and risk limits
Risk of ruin
The probability that a sequence of trades takes an account to its breach level before it reaches its target, given a win rate, a reward-to-risk ratio and a risk per trade. It is driven mostly by position size.
GFN’s figure
Against GFN's drawdown floors, risk per trade is the variable that decides survival: a 8% floor on the 2 Step absorbs 16 consecutive 0.5% losses, or four at 2%.
- 2 StepConsecutive losses to the 8% floor at 0.5% risk
- 16
- 2 StepAt 1% risk
- 8
- 2 StepAt 2% risk
- 4
A rough count that ignores compounding and trading costs; both make the real number smaller.
In detail
Risk of ruin,explained
Risk of ruin is the honest way to look at an evaluation, because it accounts for the order trades arrive in. A strategy with a positive expectancy still fails a fixed drawdown if a losing streak happens to come first, and streaks are far more common than intuition suggests.
Halving risk per trade usually cuts risk of ruin by far more than half. That is why the same strategy that fails at 2% per trade frequently passes at 0.5%, with no change to the entries at all.
Related
Terms thatcome with it
Most rules only make sense next to the ones they interact with. These are the entries this one depends on.
Maximum consecutive losses
The longest unbroken run of losing trades in a sample. Multiplied by risk per trade it gives the drawdown a strategy has historically produced, which is the figure a fixed floor has to absorb.
Position size
How many lots a trade is placed in. It is calculated from the dollar amount being risked and the stop distance, not chosen first - which is the reverse of how most traders approach it.
Fixed fractional
Risking a constant percentage of equity on every trade, so position size falls after losses and rises after gains. It is the standard position-sizing model and the one most prop rules assume.
Expectancy
The average result of a trade over a large sample, combining win rate and average win and loss. A positive expectancy is necessary for a strategy to work and not sufficient for it to pass an evaluation.
Drawdown recovery
The gain required to return an account to its previous peak after a loss. Recovery is not symmetrical: a 10% loss needs an 11.1% gain to undo, and a 50% loss needs 100%.
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