As traders one of the most important but neglected topic is Risk Management. If you want to become a consistent profitable trader risk management needs to be mastered upon. It is what keeps us in the game as traders.
During my interaction with traders 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.
What is Risk of Ruin?
Risk of ruin is a concept in gambling, insurance, and finance relating to the likelihood of losing all one’s capital or impacting one’s bankroll to the point that it cannot be recovered. For instance, if someone bets all their money on a simple coin toss, the risk of ruin is 50%. In a multiple-bet scenario, risk of ruin correlates with the number of bets, in which risk increases the longer one plays.
In Trading it refers to the amount of capital that you are willing to Risk before you must stop trading, If you understand this concept atleast 50% of trader will stop blowing off their trading account. 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!. Its like this Suppose you are having Rs 100 as your capital and you loses 50% in that, so you are left with just Rs 50 as your capital. Now You want to go back to breakeven again from your reaming capital of Rs 50. SO now a trader needs to make 100% on his trading account just to go back to breakeven ie. orginal amount of Rs 100.
How to Define Point of Ruin
Before Putting any trade Ask Yourself the below question
“What you are willing to Risk\Lose of your trading capital and put at Risk?”.
If Your answer is NONE than you should stop trading immediately as you are not aware of basic concept of trading.
As traders you must take some Risk, as you cannot make any gains without taking any Risks! 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.
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 trading capital per day. I usually recommend 1-2% maximum of account capital per day. For new traders having small capital of 1-2 lakhs risking 1% Ideally less! but to learn concept you need to adhere to it.
How to Calculate Risk of Ruin
Risk of Ruin = (1-(W-L))/(1+(W-L))^ U
W=Probability of winning
L = Probability of Losing,
^ denoted the power of U = Number of Maximum Risk Trades that may be taken
Basic aim of trader to Keep RISK OF RUIN below 0.5%
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
Example to Understand Risk of Ruin
Rahul is having trading capital of Rs 100,000 and is willing to Risk a Maximum drawdown of 30%, which is a Point of Ruin at 30,000. Lets assume Rahul 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 1000 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 Rahul 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 Raj who takes too much risk and is under-capitalised so trade in Options. He has a Rs 50,000 account and is willing to Risk a Maximum draw down of 30%, which is a Point of Ruin at Rs 15000.
Win% = 60%,
Loss% = 40%,
Risk per trade is 10% of full account at 5000 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. Raj who is an Option trader due to small account size has a high chance of Ruin.
Our main job as traders should be to reduce any chance 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 ie when you Win ride to complete trend and in loss take small loss and exit.
3. Reduce the amount of money Risked per trade and per day by trading more capital or taking less risk per trade\day.
So if you don’t already know your Risk of Ruin, make it your job to know before you take your next trade!