by In this series, I will be covering money management and risk management strategy in great depth. In this particular part, I will be discussing one of the most important concepts in money management, which is the importance of knowing the risk of ruin. After finishing this part, you will have a good understanding of how not to lose your entire capital while trading.
This entire series about money management and risk management is structured in such a way that you can understand the importance of capital preservation while maximizing your profits.
Now, many beginners who come to the stock market do not understand the importance of money management in success, and therefore I have dedicated an entire series towards this topic.
So, in case you are one of those traders who have lost money in the market, this is the concept that will help you understand why you have lost money till now. I’ve also suggested three solutions for you so that you can implement this in your own trading and eliminate the risk of ruin in your own trading account.
Risk Management Strategy Process
Now, calculating the risk of ruin is pretty simple and I have shared the formula in the post, but in case you are not familiar with Microsoft Excel, then do let me know in the comment section below and I will email the excel sheet to you. So the risk of ruin is perhaps the most important concept in trading that is not spoken about that often.
This is one concept that every trader should be aware of and yet I find very few books and tutorials mention this on a consistent basis. So this is precisely why this is the first topic I will cover in this MoneyManagement In Trading series. The reason why the risk of ruin is so important is that it will help you understand why you have lost money till now.
In simple terms, risk of ruin is a statistical measure that tells a trader the odds of losing so much money which will eventually lead one to stop trading. Now do note here that risk of ruin does not mean losing100% of capital.
For some traders will just mean losing 50% or even60% of capital. Now this varies from trader to trader and this mainly depends on risk tolerance level. Now, there are a couple of ways to calculate the risk of ruin and this is something we will cover in subsequent slides.
Let me first show you one of the most effective ways to quickly determine the risk of ruin and then to make necessary changes to avoid it. The formula to calculate the risk of ruin is given in front of you. In this formula, W stands for winning percentage, L stands for losing percentage, and N is the units of money in the trading account.
So W and L are winning and losing Percentages of your own trading strategy. The most simple way to determine this is to refer to historical backtest data of your own trading strategy. Now I’ll recommend for you analyze at least three years of historical backtest data to determine the stats for winning percentage and losing percentage.
Let me now explain what N stands for. So let us assume your account size is 100,000 and you decide to risk 5,000 per trade. N would then be calculated as account size divided by risk per trade. So in this case value of N would be 20. Let me now take another example to understand the risk of ruin calculation better.
In this example, I have taken a trading strategy that has a winning percentage of 56% and 44% is the losing percentage. Since account size is 100,000 and risk per trade is 5,000, there are 20 units of money available for trading. If you take these values and put them in this formula risk management of ruin would come about at 1%.
As a trader, you should aim for the risk of ruin to be as closer to zero as possible. In my own experience, I’ve found that reading above 4% does not work in the long run. Now that you’ve understood the basics of risk management, let me now show you three main ways that you can aim for your own risk management of ruin to be as close to zero as possible.
The first way to avoid the risk of ruin is to reduce the size of risk taken per trade. In this chart, I have taken six traders who trade with the same system which has a winning probability of 45% and a loss probability of 55%. Each trader, if you see, has an account size of 100,000 but risk management per trade is different due to their own risk management profile.
Trader one, if you see, has two units of money available, followed by Trader two, three, four, five, and six who have five units,10 units, 15 units, 20 units, and 25units respectively. Do remember here that unit of money is calculated by dividing the account size by risk taken per trade.
How much each trader risks per trade
Based on how much each trader risks per trade, Trader one has a 67% odds of losing all of his money. Trader two and Trader three have 36% and 14% odds of the same. Now do take a look at trade four, five, and six, each of these traders has just 5%, 2%, and 1% odds of losing entire capital.
The main reason for this is that they are risking a limited amount of money per trade, which in turn is helping them to preserve their capital over the long term. At this stage of your life, if you are someone who is repeatedly losing a lot of money, then begin by reducing risk per trade right away.
See at this stage you have to understand that your number one priority is not to make money in the market. If you are beginning the stock market, then your number one priority has to be to always protect your capital.
Now even after having some amount of experience in the market, my number one rule in trading is to always look after my capital. I’m never bothered about profits, I’m never bothered about losses.
The number one priority form when I get up each day is to protect my capital at all costs. The second way to avoid the risk of ruin is to trade a trading strategy that has high odds of success. In this chart, all traders that you see here have account sizes of 100,000 and all are risking10,000 per trade.
The unit of money available to each trader is 10. That is account size divided by risk per trade. Based on this chart, Trader one trades with a trading strategy that has a 51% win ratio. If you look at the risk of ruin for Trader one it stands at 67%. Similarly for Trader two, with a win ratio of 53%, the risk of ruin stands at 30%.
Now take a look at Traderfive and Trader six. With a win ratio of 60% and 65%, their odds of risk of ruin is just 1.7% and 0.2%. So as the win ratio of a trading strategy improves, it is less likely for a trader to lose his capital. I hope this point is clear.
At this stage, do compute the win ratio of your own trading strategy, and in case your win ratio is less than 50%, then either shift to a strategy with a high win ratio or start reducing your risk per trade so that you can sustain for a longer time in the market.
So till now, you know how to calculate the risk of ruin based on the win-loss ratio and units of money available.
Risk Management Strategy Examples
Let me now show you how to calculate the risk of ruin based on capital and a maximum drawdown of a system to date. So do note here that maximum drawdown is the maximum loss from high to low in a portfolio and this remains a key metric to track in risk management.
The formula to calculate the risk of ruin is given in front of you where W stands for winning percentage, L stands for losing percentage, and N is defined as total capital divided by maximum drawdown to date.
Now this way of calculating the risk of ruin is also good as this takes into account your win-loss ratio along with the capital available and drawdown based on your own trading strategy.
In this example, the win ratio is at 53%, and the loss ratio is at 47%. The total capital under consideration is 50,000 with a maximum drawdown to the date of 5,000. So the value of N, in this case, is 50,000 divided by 5,000, that is 10. Now when you put all these values in the formula given here, the risk of ruin percentage comes out to be 30%.
So at this stage, I hope you can see why recording all your trades is so important in the stock market. Unless you get into the habit of documenting all your trades in a journal, you will never be able to compute the risk of ruin metrics.
The main reason for this is you will require statistics on winning percentage, losing percentage, and a maximum drawdown of your own trading strategy.
So my recommendation for you will be to document every trade that you take in detail. Now the third way to avoid the risk of ruin is to trade a strategy that has a limited drawdown.
In this example, all traders are trading a different strategy that has a win ratio of 51% and capital for each trader is at 50,000. Trader one has a maximum drawdown of 5,000 to date and his risk of ruin stands at 67%.
Trader two, if you see, has a maximum drawdown of 4,000 and his risk of ruin stands at 61%. Similarly for Traderthree, four, and five, the risk of ruin stands at 51%, 37%, and 14%. Now take a look at Trager six here.
Trader six has a maximum drawdown of 500 and therefore his risk management of ruin is at 2% only. So in this particular example, as the amount of drawdown decreases, the odds of risk of ruin also decreases. Now as a trader, you can have a maximum drawdown of 5,000 and still lower your risk of ruin below 2%.
For this to happen though, your win ratio would have to be closer to 60%. I hope you can see how to win ratio, risk management per trade, and drawdown impact the risk of ruin for a system. Your aim here has to be to use a trading strategy that finds a balance between all these variables that we have discussed. This way, you will reduce your odds of risk of ruin drastically.
So let me now explain how you should be proceeding forward from here. Now that you understood the concepts of risk of ruin you should now calculate risk of ruin for your own trading strategy. For this, you will require a win-loss ratio, risk per trade, and draw-down statistics.
In case you do not have the same I would strongly recommend for you test at least three years of data. Your entire focus here should be to bring your risk of ruin below 2%. Now, once you’ve computed your results in case you need feedback about the same, then do let me know in the comment section below.
Conclusion
Risk Management Strategy for day trading is usually the best trading strategy to take the trade. This setup is very easy and simple to use just you need to keep patience and let your setup form and then you can enter your positions. One should follow the Risk Management, Money Management, and Fear and Greed concept of the market to avoid big losses.
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