I am often surprised to find that many traders have no idea of what their Risks are.  This involves Risk per trade, per day, per week/month and overall Risk of Ruin.  Most traders are aware of Risk per trade or per day, however very few are familiar with Risk of Ruin.  Possibly because they do not want to consider it as a possibility.  However you MUST.

So what is Risk of Ruin?  Well,  it refers to the amount of capital that you are willing to Risk before you must stop trading (Commonly referred to as “The Point of Ruin” or “Maxmimum Drawdown”).  Note this is not your full account capital, as you should NEVER risk 100% of your capital.  The Risk of Ruin is a statistical concept and is the probability of you reaching this level of ruin.   If more traders knew this they would never blow out!  Blowing out is very poor risk management!  Ideally a trader should never have a 50% Drawdown/Point of Ruin as a maximum, as they must gain a 100% return just to get to break-even!  A good recommendation to define your Maximum Drawdown (Point of Ruin) Level is ask yourself “What you are willing to Risk\Lose of your account capital and put at Risk?”.   None is not an answer! Because as traders you must take some Risk, as you cannot make any gains without taking any Risks!  It is imperative that you know what your risk is and are willing to embrace it.  if you are not willing to take any Risk on your account, then you CANNOT TRADE, it is as simple as that.  Ideally you should be willing to Risk at least 25-30% of your account as a maximum drawdown\point of ruin before you must stop trading, and then review your business\trading plan for new objectives and risk parameters to determine if you can still trade, then build a new plan if required.

As traders our job is to avoid reaching our point of  Ruin.  So you must work out your probability\chances of reaching this level of drawdown.  In its simplest terms the more you risk per trade and per day, the more you increase your risk of ruin.  So the easiest way to avoid Risk Of Ruin is to only risk a small amount of your account per day.  I usually recommend 1-2% maximum of account capital per day.  For new traders 1% (Ideally less!) at most.  Note per that’s per day NOT per trade!

There is a formula for working out your Risk of Ruin, and ideally you Risk of Ruin should be between 0 % – 0.5%.  NOTE: It is mathematically impossible for the risk of ruin being 0.0 percent!  So the aim is below 0.5%, which when rounded down is 0%.  When you get above 1% and higher that’s when you know you are risking too much, and the risk of Ruin is becoming positive, meaning that its only a matter of time before could blow out and reach you max drawndown level!  Therefore it is advised that you DO NOT trade until you are comfortable that you can perform (With simulated trading if you are a discretionary trader or on a back-test  for an automated system) at a level where Risk of Ruin is less than 0.5% and ideally towards 0% as possible.

There are a number of ways to calculate Risk of Ruin, however the most common formula is:

Risk of Ruin = (1-(W-L))/(1+(W-L))^ U (Where W=Probability of winning, L+ Probability of Losing, ^ denoted the power of U + Number of Maximum Risk Trades that may be taken).

You can also find a more advanced formula with a useful calculator HERE.

Here is an example of trader A with a $50,000 account and is willing to Risk a Maximum drawdown of 30%, which is a Point of Ruin at -$15,000.  Lets assume Trader A has proven through his trading that he can gain the following averages: Win% = 60%, Loss% = 40%, Risk per trade is 1% of full account at $500 so max trades he may take and lose sequentially is 30 trades before he reaches the Point of Ruin (Max Drawdown).

So his Risk of Ruin is worked out as follows:

(1-(0.2)/1+(0.2))^30 =

(0.8/1.2)^30 =

(0.666666)^30 = 0.000005214 = 0% (When rounded down).

Which is a VERY low Risk of Ruin!  This allows for this trader to take risk comfortably knowing that there is very little chance of ruin.  Of course this assumes that the trader keeps performing well!  If the Win rate and Win to loss ratio adjusts over time the Risk of ruin may increase\decrease.

Now lets consider Trader B who takes too much risk and is under-capitalised.  He has a $10,000 account and is willing to Risk a Maximum drawdown of 30%, which is a Point of Ruin at -$3000. Win% = 60%, Loss% = 40%, Risk per trade is 10% of full account at $1000 so max trades he may take and lose sequentially is 3 trades before he reaches the Point of Ruin (Max Drawdown).

So his Risk of Ruin is worked out as follows

(1-(0.2)/1+(0.2))^3 =

(0.8/1.2)^3 =

(0.666666)^3 = 0.2962954074083 = 30% (Rounded up)

That’s a big difference, with the same technical performance but a smaller account and more risk.  Trader B has a high chance of Ruin.

Our main job as traders should be to reduce any chance of ruin.  Any probability in favour of ruin is not good!  You as the trader are in control of your risk of ruin.  Therefore it’s essential to Position Size and Manage Risk accordingly for each trade and every day so that Risk is minimal, and Risk of Ruin is kept to the minimal.

So lets consider the ways that you can reduce your risk of ruin:

1. Increase your accuracy and obtain a Higher Win%.
2. Increase your Win to average loss pay-off ratio.
3. Reduce the amount of money Risked per trade and per day by trading more capital or taking less risk per trade\day. (Everyone can do this one – at least reducing risk!)

So if you don’t already know your Risk of Ruin, make it your job to know before you take your next trade!

Example of my Visions and expectancies for the Emini S&P on 2nd March 2012, and then how the market played out as well as how I traded it (Click to Enlarge):

Example of my trade on the Euro Bund on  2nd March 2012 (Click to Enlarge):

Example of my Visions and expectancies for the Emini S&P on 1st March 2012, and then how the market played out as well as how I traded it (Click to Enlarge):

Example of my trade on the Euro Bund on  1st March 2012 (Click to Enlarge):

Example of my Visions and expectancies for the Emini S&P on 29th February 2012, and then how the market played out as well as how I traded it.  As close as spot on, as you can get! (Click to Enlarge):

Example of my trade on the Euro Bund on 29th February 2012 (Click to Enlarge):

One of the major turning points in my trading career came when I realised that nearly all trading systems or methods attempted to highlight the SAME set up’s!  Yet some traders will be successful trading them and yet most will fail.  Although we all know that a lot of this is down to an individual traders Psychological make-up, there a few things that traders wanting to stand a chance must realise.  Firstly, the real trick is to establish WHEN to trade WHICH set-up’s and WHEN they are best left alone and you are better of sitting on your hands.  One of the simplest ways to establish this is to know what Phase (Balanced\Range Bound or Trending\Imbalanced) the market is in.  This is Step 1 of the L2ST Trading Game Plan.  Which by the way is NOT a system, it’s “A way of Understanding the Markets so that you stand a chance of trading them better”.

Nearly all trading methods\systems are designed to trade ranges by either fading or going with the break-out, and most commonly they are designed to highlight trends and then join a trend.  Most automated systems\traders fail overtime because they attempt to do one or the other all of the time.  The markets do however Balance and become Range Bound, and they do also become Imbalanced and start to trend directionally.   That’s why most systems designed to do one or the other will usually have some successes, especially short-term.

We have to remember that WHEN each phase takes place is down to the market and it’s participants, we don’t control that.   However, we must observe the market and understand what it has done, what it is doing right now to better understand what it might do next.  Knowing your market should be Common sense for traders.  The dilemma most traders face, is that under different phases they must be prepared to take what may be the opposite trade to what you would in another phase.  For example Fading an Imbalanced\Trending Market is very different to Fading a Balance\Range Bound market.  The odds of the trade working out change in the moment depending on the phase the market is in,  and not based upon some statistics of a back-test!  I often say that nearly all trades are 50\50, what defines if it has a better chance of working out is the current market phase, as well as what the market participants are doing in the MOMENT.  It is when you put things into perspective in that moment that you gain your EDGE!

Discretionary Trading and the methodology I teach at L2ST is all about highlighting the correct market phase at any given time and then trading it accordingly.  I call this “The Art Of Adaptive Trading”.  In its most simplest form, if the market is Range Bound and Balanced (Trading around an area of Established Value) the focus should be to trade the market by fading the Rallies into Resistance areas\levels or Sell-off into Support areas\levels.  If it is Imbalanced\Trending then this must be recognised and the focus shifts to buying pull-backs and selling bounces off my levels.  Not rocket science, when it comes to set-ups, it just makes a lot of sense.  The levels (Areas of doing business) I establish are normally derived from Market\Volume Profile areas of Rejection or Low Volume, again for a simple and logical reason.  The idea is that because the market has proven (Through Market Generated information)  it is rejecting those areas through the lack of trade facilitation, it is likely to reject again.  Of course it may not reject, but that’s the expectancy.  So if it looks like I am seeing what I expect I get in and then start to manage the trade.  Trade Management is where the money is made or lost for traders and not in the set-up or entry.  Some do forget that simple truth.    You can have the best set-up and entry in the world and still mess it up through poor trade management, which is another subject altogether!  However taking a trade set-up at the RIGHT time does improve your odds of having to manage a trade that has a better chance of working out rather than one that as a greater chance of failing to play off.  Most common Price Action Trade Set-up’s show up within these different phases, and they all work! You just have to get good at trading the right ones at the right times!  (See the examples below).  However, I must add that the breakouts of ranges are the ones that are the toughest to time well, and for that reason those are the ones that I often avoid.  Is it a coincidence that most novice traders  focus on taking the trades that I would most prefer to avoid, which is the breakouts?

Characteristics of Balanced\Range Bound Markets

A Balanced Market is established when the market has already found Value within a sideways\rotational range.    All markets spend most of their time in this phase, as it fulfils the purpose of the market to facilitate trade most efficiently and effectively.  Markets are generally balanced over 80% of the time.  Hence the reason why Range Trading can be so effective and profitable, even more so than trend trading when done right!

- Most of the Volume traded is within the middle\centre of the range.
- Symmetrical Volume at Price Distribution (See Below)
- Less Volume traded around highs\lows and therefore proof of rejection at the highs\lows of the range.
- Flat VWAP and 1^st standard deviation bands.
- Price is attracted back to the middle of the range (VPOC\VWAP) as it tries to move away outside of value areas range.
- 100-80% retracements in Price swings.  Extensions may occur above and below value up  to around the 127-161.8% Fibonacci Retracement Extensions of the range’s high-low or low-high.
- Market will usually find Buyers below \sellers above Value for up-to 3-4 swings before an attempt for a move away from value.  1st\2nd and 3rd Swing’s provide highest probability trades.

Balanced and Imbalanced Market\Volume Profile, VWAP and Price Action Example:

Characteristics of Imbalanced\Trending Markets

An Imbalanced Market is established when the market participants perception of Value has changed and they are now willing to accept prices above\below value.  This causes the market to move directionally and an inefficiency is created whilst we are in search of a new area of Value, where two sided trade can be found, and the return back to efficiency.  The market will Balance again, it’s just a case of when.  Whilst the market is imbalanced and is seeking value, your job as a trader is to GO-WITH the imbalance and NOT fight it.  Markets are imbalanced less than 20% of time.

- Most of the recent Volume traded is falling outside of prior value.
- Asymmetrical Volume at Price Distributions starting to occur, usually you will see 2-3 new distributions outside of a prior key area of value, with market not spend much time in each new distribution (usually less than 1.5 hours).  (See Imbalanced Profile Above)
- More Volume will trade into new highs\lows as the market continues its attempts into new highs\lows.
- The market will retrace and test DEVELOPING LVN’s in today’s profile and find new trade that will initiate further movement in the direction of the Trend (See Imbalanced Long Set-ups Above).
- Trending VWAP and 1st standard deviation bands (turning up\down).  Market will commonly retrace back to its 1^st SD High of VWAP in an uptrend, and to its 1^st SD Low in a down trend.  At times it will also pull-back\bounce as far as the VWAP.
- Price is pulling away from to the middle of the prior value areas range and fairest VPOC prices.  The developing VPOC may start to shift in the direction of the markets movement.
25-60% retracements in Price swings are possible and the market may still sustain its trend.
- The prior value areas 127.2-161.8% Fibonacci extensions start to break with momentum and volume at price acceptance starts to occur away prior acceptance area.

However, I would like to take this moment to find out if there would be any interest in Pre-Market Analysis in more detail as a a paid service some time in the future? if you might be interested then please fill out THIS SURVEY

At this point I am only considering this as an option if there is enough interest in such a service. If there is not enough interest then I will not be offering the service.

Thank you for taking the time to consider a response.

Kam Dhadwar
Trader and Owner of L2ST

The question was what steps can be taken to move from a “Trading not to lose” mindset to a “Trading to win” mindset. As with mostly anything in life, the simple things often work best to at least START shifting the mindset in the right direction. However, although some knowledge can lead to one acting, only continuous practice of doing the right things will reinforce better ways of thinking and being as a trader. A Traders Wisdom only comes through DOING what is right. Conscious doing can lead to the first few steps, but for one to stay on the path they must be able to shift this to their unconscious.

Here are few suggestions:

1. Clearly define your Risk per day, so you know what you are willing to Risk (lose) if things don’t go well. Embrace Risk and Love it because its all a part of the game!
2. Clearly define your Goal\Objective for the day. Generally 1-2% of account per day as a goal is good for a day trader. Matching the risk with objective is a good idea, or aiming higher than what you plan to risk.
3. Never take more risk than you can afford with your account. I usually recommend traders risk no more than 1-2% of their account for any give day. If you hit the risk limit then you stop trading, otherwise you must stay Fully Engaged and Focused in reaching your Objective\Goal for the day and consciously trying the trade to trade well, whilst following the plan to the best of your ability.
4. Visualise you day and how you plan to trade before the market opens, and with each opportunity Visualise in you minds eye what you want to see if you are right with your trade idea.
5. Also know what you don’t want to see in advance so that you can get out if it doesn’t look good.
6. Understand that the market is Uncertain at all times, there is No certainty, so never look for it. EMBRACE Uncertainty.
7. Fully accept that every trading opportunity is just an idea, it can just as easily be right or wrong. if it looks right work the trade the best you can, if it looks wrong cut your losses. An old adage but very important to practice, and not just know.
8. Continuously build Belief and Confidence in your plan, and the concepts\ideas that you trade. I fully believe in Auction Market Theory principals and the power of Volume Profiling, as well as the use of order flow. That’s what helps me trade well with the tools. If you don’t believe in the way that you trade then its difficult to make money.

I’ve course there is much more that can be done, but these are just a few of things that I practice daily to keep me on top of my game.

Kamd Dhadwar – Owner L2ST

I have officially stopped trading today for the rest of the year (from today) until 3rd January 2012. Therefore I will not be performing any Pre-Market Analysis until 3rd January 2012, when I return back to the trading arena. It has been a fantastic year for trading, and I continue to grow and better myself every year. Next year will be no different, with new Goals and Objectives set at higher levels! Can’t wait!

I would like to wish everyone a Merry Christmas and Very Prosperous 2012!

Warm Regards

Kam Dhadwar
Trader and Owner of L2ST