Risk of ruin
What is the chance that a run of losses wipes out a trading account before the edge can show up?
In plain words
Risk of ruin is the probability that losses accumulate, often with leverage, until the account's capital is exhausted and the position can no longer be held. It depends on how much is risked per trade, how big the losses can be, and how long the losing run lasts.
Why it matters
A strategy can be profitable on average and still destroy an account if the losing stretches arrive before the winning ones. Sizing each position as a small fraction of capital lowers the odds that any single week, or any sequence of weeks, ends the game.
In a real week: ETH, week of 23 May 2022
In the week of 23 May 2022, ETH fell 11.23%, with a worst day of -7.74% on 26 May and a largest one-hour move of -4.79% also that Thursday. The four prior weeks were all down: -3.29%, -10.8%, -14.86% and -4.76%. Realised volatility ran at 79.6% a year, so a leveraged long could be exhausted by the sequence rather than by any single hour.
A common mistake
Treating ruin as a single-trade event. A run of ordinary-sized losses over several weeks can exhaust an account just as effectively as one large loss.