Is your trading profitable in the long run? Hands up who has ever blown up a trading account? Or maybe you adopted a poor trading strategy and lost most of your account? If something like this happened to you, don’t feel bad. Almost all traders experience some sort of account depletion in their trading at some point. The good news is that we can learn from our mistakes in a big way. There is a single (and easy) concept you can learn that can prevent major account explosions from occurring. If you want to be able to continue trading for the long term, turn your attention to the risk of ruin.
The risk of ruin is simply the probability that your account balance will reach zero (or some sort of major withdrawal). Based on your trading data from your predetermined trading strategy, you can calculate the chances of your account being wiped out. You can’t prevent your account from being wiped out, but understanding the risk of ruin can help you avoid reaching and exceeding a desired maximum withdrawal.
Why you need to know your risk of ruin
If you’re going to trade for years, rather than months, weeks, or days, you need to know your risk of ruin. This is what I try to tell every person interested in trading: “If you treat the market like a slot machine, it will eat your money for breakfast.” I don’t know how many times I’ve heard heartbreaking stories of people risking everything on one, two, or just a handful of operations and ended up losing everything. Too often, people enter the market because they want to alleviate an immediate financial burden and end up burning themselves because they are in a hurry to make immediate profits. Knowing the risk of ruin can eliminate that fly from the seat of your pants attitude towards trading. It helps traders trade more responsibly, keeping risk in mind with every trade.
How to understand the risk of ruin?
How is ror calculated?
If I were to try to tell you the formula of the risk of ruin, you would probably run screaming for the hills. If you’re a super nerd (like me) and really want to watch the formula, you can check it out here. For the non-nerds out there, we have a better solution. We have a free, amazing and easy-to-use calculator that will do everything for you. But first you need some information related to your strategy. To successfully find out your risk of ruin, you must first set a maximum risk percentage on each trade. Next, you will need to set some rules, determine your trading strategy and be consistent. In addition to your strategy, it’s important to set a take-profit goal using a risk/reward ratio or average profit percentage.
Once you’ve straightened out your strategy, risk, and reward, determine how much money you should lose in your account that would really make you angry, through your maximum downward withdrawal. Then you need to start tracking your trades on paper (or more likely using a spreadsheet). Once you have recorded some data. Finish by entering your numbers into our risk of ruin calculator. You can also play with different numbers and find a balance that works well for you. Try it, then go back to the calculator and edit your numbers again. See below for more detailed instructions on how to prepare for the risk of ruin calculation:
Set risk on the percentage of your account
Knowing the correct percentage of risk will help long-term trading.
One of the first things you need to understand is how much you will risk per trade. This is usually done as a percentage of your account. Many experienced traders recommend a maximum risk of 2% per trade and scaling as your account grows. So the higher your account, the lower the percentage you might want to risk. The idea here is simple, the lower the percentage you risk per trade, the more times you can lose and keep your account balance alive. Take it into consideration. Let’s say you have $1,000 in your account. If you risk 2% it means that you could lose 50 times in a row (even more if you consider the composition) and still maintain a balance. What happens if you risk 1%? This gives you even more trades before you blow up your account, 100 trades. How about 0.5%? That means 200 trades before you blow up your account. So the lower the percentage, the more you can make mistakes and still keep your account afloat. And believe me, you will lose some trades and at some point you will hit a losing streak. By keeping your risk percentage low, you will keep your trading account in a much healthier position. Ultimately the number is up to you to decide, and using our risk of ruin calculator you can play with the numbers that work best for you.
Find a strategy and follow it
Choosing a good strategy will help you succeed.
Another thing I always tell traders is: be consistent. I will be the first to admit it, it is easier said than done, but no less important to have in place for successful trading. That’s why we need very specific rules that we can follow every time we take an exchange. If there’s a flaw in your strategy or an area that you think could be improved, you can always change one or more of your rules. But you can’t accurately track the success of your strategy if you just follow a couple of rules or change the rules arbitrarily. Strategy is important, but if I can be honest with you, it’s not the most important thing. Managing your money well is the most important part of trading. Anyone can make big gains and win a lot of money in a short amount of time, but ultimately your ability to trade long-term depends on how well you manage your money, which starts with understanding the risk of ruin.
Determine your profitability (profit factor)
Knowing the profitability of your strategy is another key piece of data to determine the risk of ruin. There are a couple of ways you can determine your profitability:
First you can have a set risk/reward ratio, which is fixed with each trade. For example, a 2:1 risk-reward ratio means that for every $1 you risk, you expect to earn $2. So your take profit strategy can be set on this, and you either win the trade with a win of $2 or lose with a loss of $1. This is probably the easiest to determine and calculate, but in reality profits and losses will probably be a bit more dynamic.
Secondly, you
have a less fixed risk/reward ratio, perhaps on one trade you make 1.5x your risk, on the second trade you make 2x your risk and on the third you make 0.5x your risk. To calculate this method all you have to do is calculate the average win ratio of all your winning trades. For example:
1.5 + 2 + .5 / 3 = 1.33
That’s all you need to calculate your profitability.
Determine your maximum acceptable withdrawal
Knowing your maximum downward throw can prevent a lot of distress.
Withdrawal is a percentage of the total loss of the account from the peak of profitability to the minimum of maximum losses. Understanding this number is ultimately up to you, based on your risk tolerance. My suggestion is to ask yourself this question: how much money could you lose before you get so angry that you make a hole in the wall? And then halve that amount. This is not trading advice, but my best suggestion would be to set that number somewhere between 10% and 25%. If you’re a little more or less risk-tolerant, feel free to adjust that number to what suits you best.
Record your trades – Know your winning percentage
Before you get to the calculator (keep your horses, we’re almost done), you need to add all this information together and use it to start tracking your trading results. It doesn’t have to be anything special. You just need to know your win percentage and your average profit factor. Once you’ve developed some sort of track record with your strategy, you can start writing your trades. Not only will journaling help you know your risk of ruin, but it will also make you an overall better trader. There is something about having real data at your fingertips, which allows you to make more informed decisions about your trading. Seeing that you have been tracking your trades and now have the chance to know your win percentage and other variables, can have a major impact on everything your overall success rate.
Here’s an example of what you can do. If you are trading Forex, you are trading on a demo account. Try to track 50 operations. Be consistent with your strategy. Analyze your data. You can connect it to our ruin risk calculator. If the calculator gives you a low chance of hitting your maximum draw-down, great job! You have made a consistently low risk strategy. If the calculator says your risk of ruin is high, well, you might want to tweak your strategy and attempt to make 50 more trades under the new rules. You can always go back to our calculator to run your numbers again.
If you’re a little intimidated from starting your trading journal, don’t worry, because we’ve got you covered. We have a free Forex trade monitoring spreadsheet that you can download here (coming soon).
Use our risk of ruin calculator
Finally – I know you’ve waited a long time to get to this point – we can talk about the risk of ruin calculator. This handy calculator can make your life easier and help you manage risk in a very practical way. Our calculator is easy to use and you only need 5 data points to understand your risk of ruin based on your current strategy. If you have followed this strategy guide and monitored your trades, all you have to do is enter your numbers.
The data points you need to enter are, win rate, average profit/loss, risk per trade, number of trades and max draw-down%.
Once you’ve entered the numbers, click the Calculate button. You will get a percentage of the chance that you will reach your risk of ruin. The lower the number, the better the risk management of your strategy.
Conclusion
As you’ve probably figured out by now, ruin risk is an essential metric to be able to trade for the long term. By understanding your risk of ruin, you can greatly reduce the risk in your trading strategy. It will also help you optimize your strategy so you can find the perfect balance between the percentage of risk per trade, the payout percentage and the profit factor. In addition, by entering your operations in the diary, you will be able to collect the necessary data to be fully able to calculate your risk of ruin. Don’t let your trading strategy suffer by ignoring the potential benefits that risk of ruin can have for your strategy.