As traders one of the main concepts that we must master is Risk Management. It is what keeps us in the game as traders and ultimately leads to better chances of profitable trading if we manage our Risk well.
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:
(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
(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:
- Increase your accuracy and obtain a Higher Win%.
- Increase your Win to average loss pay-off ratio.
- 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!