Risk of ruin and Monte Carlo

What it is

Risk of ruin is the probability of losing a set part of the account (say 10%, or a prop firm's maximum drawdown) before reaching your goal. It depends on win rate, payoff and, most of all, how much you risk per trade. Even a profitable strategy has a real chance of ruin if risk per trade is too high.

A Monte Carlo simulation estimates it by reshuffling your actual trade results thousands of times and seeing how often the drawdown limit is hit. It also shows the range of drawdowns and losing streaks to expect. For a prop challenge, it's effectively the probability of failing it.

How to spot it

• Losing streaks are longer than people expect: at a 50% win rate, a run of 7 losses in a row is common over a few hundred trades.

How to use it

• Lower risk per trade until the simulated chance of hitting the drawdown limit is small.
• Use the expected worst drawdown to set your personal daily and total loss limits.

Common mistakes

• Assuming the backtest's worst drawdown is the worst you'll see.
• Raising risk to pass a challenge faster, which raises the chance of failing it.

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