As a trader, one of the main concepts you need to master is risk management. This is what allows you to stay in the game and have a better chance of earning money off of the markets.
Many traders have no idea how much risk they are taking on each trade, per day, or per week, or their overall risk of going broke. And those traders who do know their risk per trade or per day are often not (or hardly) familiar with the risk of bankruptcy. Most likely because they don't want to see it as a possibility.
Many people will talk about Risk-Reward ratios such as it’s important to have 2:1, 3:1, or whatever to one ratio, but this is just the tip of the iceberg of risk-management and leaves you uninformed and un-empowered. You can actually have a 3:1 Reward-Risk ratio and lose all the money in your account. You can also have a 1:1 Reward-Risk ratio and make money day in day out.
How can you understand the difference between the two? Through the Risk-of-Ruin formula.
Risk Management and the Risk of Ruin formulas are very critical, whether you are trading Price Action Strategies, Elliot Waves, or any other system.
What is your risk of ruin?
This is the amount of capital that you are willing to risk before you have to stop trading (commonly referred to as the "ruin point" or "maximum drawdown"). Note that this is not the total capital in your account, as you should NEVER risk 100% of your capital.
The risk of ruin is a statistical concept that matches the probability that you will reach that level of ruin. Ideally, you should never have a drawdown of 50% or less, because then you'll a 100% return just to break even!
It is obviously not possible for a trader to profit without taking some risk, but it is imperative that he/she knows what his/her risk is and that he/she is prepared to take it. If a trader isn't prepared to take risks on his/her trading account then trading is not for him/her, it's that easy.
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Ideally, you should be prepared to risk 25-30% of your account as a MAXIMUM point of ruin before you need to stop trading, then revisit your trading plan for new goals and risk settings to determine if you can continue trading, then develop a new plan if necessary. You may also need to consider psychological venture capital, how willing are you to take risks on your own trading account? At what level of loss would you begin to feel uncomfortable trading with confidence?
Considering most traders who are starting out - they're highly risk averse, and might experience a loss of confidence with just a bit of drawdown, whereas more experienced traders who accept risk may endure a larger drawdown while keeping the confidence to keep moving forward.
As a trader, our job is to avoid reaching our point of ruin. You must therefore calculate your chances of reaching this drawdown level. Simply put, the more you risk per trade, the more you increase your risk of going broke. So the easiest way to avoid the risk of going broke is to risk only a small portion of your account. I generally recommend a maximum of 1-2% of the account principal (1% for new traders).
Any probability in favor of ruin is not good! It is therefore essential to determine the size of the position and manage the risk accordingly for each trade so that the risk is minimal and the risk of bankruptcy is kept to a minimum.
So let's see how you can reduce your risk of bankruptcy:
- Increase your accuracy to get a higher % of winning trades. (Win Ratio)
- Increase your average profit/loss ratio. (Pay Out Ratio)
- Reduce the amount of money at risk per trade.
What is a good risk of ruin?
In general, everything around and below 1% is acceptable but of course, that depends on the trader's risk appetite.
Risk of Ruin Tables
