Risk Management Glossary — Drawdown, Position Sizing, Kelly Criterion

Risk management is the survival layer of every trading system. Edge without risk management is fragile; risk management without edge is just slower failure. Profitable trading requires both, and the risk side is generally less interesting to study but more important in practice. This cluster collects the core risk-management concepts.

The foundational metric is drawdown — the worst peak-to-trough decline in equity. Maximum drawdown is the single most important risk metric for evaluating any strategy: it represents the worst experience a trader using the strategy has had. Recovery from drawdown follows a known mathematical formula: a 50% drawdown requires 100% gain to recover; a 30% drawdown requires 43% gain. Understanding this asymmetry shapes position-sizing decisions.

Position sizing connects edge and risk. The Kelly criterion provides the mathematical optimum: f* = (bp − q) / b, where b is the win/loss ratio, p is win probability, q is loss probability. Full Kelly maximises geometric growth but produces psychologically unbearable variance; most traders use fractional Kelly (25-50% of full) to balance growth and drawdown.

Stop-loss is the trader's hard floor on per-trade risk. A trade without a stop-loss has unbounded downside — the same loss profile as an unhedged short option. Every position must have a stop, with the stop placed before the trade is taken (not 'set after I see how it develops'). This discipline is non-negotiable.

Risk-reward ratio (per-trade reward target divided by per-trade risk) combined with win rate determines expectancy. A 1:1 risk-reward strategy needs a win rate above 50% to be profitable; a 3:1 strategy can be profitable at 30% win rate. Strategy design involves trading off win rate against reward-to-risk, with both contributing to expectancy.

Leverage and margin amplify both edge and risk proportionally. High leverage (1:500+) is sometimes marketed as opportunity but is primarily a tool for blowing up accounts faster. Professional traders typically use effective leverage of 1:3 to 1:10 in absolute terms; the high leverage offered by retail forex brokers is rarely used at full capacity.

Risk-of-ruin is the probability that a strategy will eventually destroy the account given its edge and position sizing. Even positive-expectancy strategies have non-zero risk of ruin if position sizing is aggressive; this is the mathematical justification for conservative sizing.

For evaluating any EA: insist on transparent drawdown profile across full regime exposure, hard stops on every trade, and conservative default position sizing. EAs that produce 'low drawdown high returns' typically hide risk through grid recovery or martingale logic that has not yet experienced its failure scenario.