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Risk of drawdown

The probability of reaching a specified decline at some point, which is much higher than beginners expect even for good strategies.

risk-of-ruin asks about total loss, which is rarely the relevant question - almost nobody trades to zero, they quit first. Risk of drawdown asks the practical version: what is the chance this account sees a 20% decline in the next year?

Estimate it by simulation rather than formula. Take your realised r-distribution, draw a year's worth of trades at random a few thousand times, apply your sizing rules, and count how often each path touches minus 10%, minus 20% and minus 30%. A profitable system risking 1% per trade over 250 trades a year typically shows a 20% drawdown probability well above 50%, which surprises nearly everyone the first time.

The number is what your loss limits must be set against. A limit tighter than your routine drawdown probability will fire in normal conditions and teach you to ignore it.

Related: risk-of-ruin, monte-carlo-reshuffle, drawdown-throttle, consecutive-losses

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

An equity curve and its drawdownAn account balance rising over a year, falling from a peak to a trough, then climbing back to the old peak.ACCOUNT EQUITY$20k$12k$8k024681012TIME (MONTHS)PEAK $16,000TROUGH $12,000DRAWDOWN−25%RECOVERY
Equity curve and drawdown. An account balance plotted month by month. The fall from the $16,000 peak to the $12,000 trough is a 25% drawdown, and the shaded area lasts until the balance climbs back to the old peak.
Risk of ruin against risk per tradeA curve climbing steeply as the share of the account risked on each trade grows, even though every trade carries a small positive edge.CHANCE OF LOSING THE ACCOUNT0%20%40%60%80%05%10%15%20%25%RISK PER TRADE (% OF ACCOUNT)2% → 1.8%5% → 20%10% → 45%20% → 67%assumes a 52% win rate at 1:1, ruin = account goneruin chance = (0.48 ÷ 0.52) ^ (100 ÷ risk %)
Risk of ruin. The chance of losing the whole account, plotted against the share of it staked on each trade, for a method that wins 52% of the time at even money. The edge is the same all along the curve; only the bet size changes.

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