Chapter 2 of 8
Portfolio heat, drawdown and practical ruin
Move beyond per-trade risk: examine correlated positions, cash obligations, losing streaks and the capital needed to remain operational.
In this chapter
Three symbols can be one bet #
A long index future, a long banking-stock position and a bullish option spread can all be exposed to the same market decline. The symbols are different; the dominant risk driver may not be. Sum standalone planned losses as an initial heat measure, then build simultaneous adverse scenarios. Do not rely on a correlation estimate from calm daily returns to describe an intraday crisis.
Maintain separate columns for planned stop risk, plausible gap loss, contractually bounded expiry loss, available cash and settlement obligations. These quantities answer different questions. Adding them indiscriminately double counts some risks and ignores others.
Make the denominator explicit #
A 20% fall requires a 25% gain on the remaining equity to recover. More generally, recovery return is d/(1−d), where d is the drawdown as a decimal. At 50%, the required recovery is 100%. That asymmetry is arithmetic, not a forecast of how long recovery will take.
Fixed-fraction sizing reduces the rupee allocation as the account shrinks, but does not eliminate practical ruin. An account can become too small to take a valid whole lot, meet funding requirements or tolerate costs long before its balance reaches zero. Borrowed capital adds repayment obligations that the strategy’s statistical horizon does not suspend.
Do not invent a risk-of-ruin percentage #
A formula based on independent, identical wins and losses can be misleading when losses cluster, execution costs change or the strategy changes regime. A finite sample with no catastrophe is not evidence that catastrophe has zero probability. State the assumed win probability, payoff distribution, serial dependence, capital floor and replenishment rule before discussing a ruin estimate.
For a practical research stress, replay the largest historical adverse sequences, increase slippage, reduce liquidity and include operational downtime. Preserve sequence dependence where possible. These are scenario tests, not a probability guarantee.
Cash can run out before the thesis fails #
Mark-to-market debits and margin changes can force an exit even when a longer-horizon hedge is economically sensible. Eligible collateral is not automatically spendable cash. A portfolio dashboard should show when each cash obligation can arrive and whether cash is actually available then.
Assess the same adverse market state across all positions. A fall in collateral value, a larger haircut and a futures debit can occur together. Financing stress should not be modelled as a set of unrelated, politely spaced events.
Hypothetical worked example
An illustrative risk cluster
Suppose three paper positions have planned losses of ₹1,000, ₹1,500 and ₹800. Total planned heat is ₹3,300, or 1.65% of ₹2,00,000. If a common gap scenario produces losses of ₹2,200, ₹3,000 and ₹1,200, the scenario loss is ₹6,400, or 3.2%. Neither is a statistically calibrated worst case.
After ten losses at a fixed 2% of remaining equity, capital is about 81.7% of its starting value before extra costs. Ten losses of a fixed 2% of starting equity leave 80%. Compare the assumptions before arguing about which path is safer; the minimum tradable lot and cash requirements can dominate both.
Common mistakes
- Assuming separate tickers imply independent risk.
- Calling a backtest drawdown the maximum future loss.
- Using margin deposited as the denominator of investment return.
Why can practical ruin occur before account equity reaches zero?
Make this chapter useful
Can you defend the reasoning?
Before moving on, answer the self-check in your own words and write why each alternative fails. Use the worked example to test that explanation. Then apply it in the module research task; keep the assumptions and the evidence that could change your answer.
Sources and further reading
- CME Group: defining a trading plan ↗
- CME Group: position size, stop distance and risk ↗
- NISM: equity derivatives learning objectives and strategies ↗
- Bailey et al.: The Probability of Backtest Overfitting ↗
- NSE Clearing: settlement mechanism ↗
- NSE Clearing: equity derivatives margins ↗
Further-reading references from the curriculum source list. Contract sizes, expiry calendars, settlement references, margin parameters and tax treatment can change; verify the current operative documents for the actual product. Worked figures are illustrative, not current quotes.
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General financial education. No securities recommendation, assured outcome or personal advice. Read the risk disclosures.