Risk Of Ruin In Trading
HOW TO LOSE ALL OF YOUR MONEY TRADING FOREX! Traders with some experience may have heard of the term, but I guarantee you that a lot of traders don’t understand it.
That opening line may have scared you, but don’t worry, because the point of this is to learn how to reduce the risk of losing your capital.
SPOILER ALERT! This article might get a little nerdy for some of you, and include some numbers, which are the cornerstone of successful Forex trading.
So if you’re a bit preoccupied, drop your sandwich and pick up your coffee (or chewing gum, whatever works for you), and get ready to get familiar with some numbers.
If you do not understand this, your Forex trading journey may be a short-lived one. What I am about to tell you, will ensure that you never blow another account. So listen carefully and embrace the numbers.
First! We have to breakdown the probabilities of trading. WHAT ARE YOUR CHANCES of making money in the Forex market, or any market for that matter?
TWO numbers stand out when calculating probabilities – HOW OFTEN you win, and HOW MUCH you win when you do. These two things are very important but… they should always be compared to YOUR LOSSES.
Trading is a game of battling your losses. You’re trying to lose LESS OFTEN and LESS MONEY. Your losses can be your undoing very quickly in this market. So that begs the question, how should you look at the PROBABILITY OF LOSS in your trading?
The table above might seem kinda intimidating or complex, so let’s walk through it. This table shows how frequently you can expect a certain number of losses to occur in a row, using your trading system.
If you don’t have a system, find one, FAST! And if you don’t know the WIN RATE (roughly the percentage of winning trades you expect out of all your trades e.g. if you win 60 out of 100 trades, you have a 60% Win-Rate), then back-test your system and find out how often you win on average. Back to the probabilities…
Let’s start with a 50% Win Rate.
This is almost like flipping a coin. You have a 50% chance of losing that one trade.
Now let’s say you decide you’re going to flip the coin TWICE. What are the chances that you’re going to lose the coin toss TWICE IN A ROW? There is a 25% chance of that happening.
THREE TIMES IN A ROW? There is a 12,5% chance that you going to lose 3 coin tosses in a row!
And a 6% chance of you losing 4 in a row.
Now, let’s say your strategy win rate is better than a coin toss. Let’s say your Win-Rate is 66% right?
Off the bat! You know that whenever you place a trade, you a 34% chance of losing that one trade.
With a Win rate of 66%, the chances of you losing 2 trades in a row, is just 11%! But it is still very possible to lose again. What about 3 times?
The probability of losing 3 trades in a row is about 4%!
Hopefully, you understand the probability of certain drawdowns in your trading depending on your Win-Rate because now we get to the gravy! How to measure your RISK OF RUIN based on this same table.
RISK OF RUIN
I think the term accurately describes what we are about to measure. We wanna find out HOW MUCH TO RISK, without blowing our accounts? HOW MUCH TO RISK so that we can SURVIVE a drawdown?
Here is the same table again, so you do not have to scroll up and down for miles.
Again let’s start with a 50% Win Rate (Coin toss)
Although you should never do this, if you risk your entire account on each trade, your risk of ruin is ONE. The reason being, even if you survive a couple of trades, it will only take one trade to wipe you off the face of this earth.
Let’s say you’re not THAT crazy, but you’re still an adrenaline junkie. So you risk 50% of your account on the coin toss (each trade). That means if you lose TWO tosses IN A ROW, then you’re BROKE.
According to our table, if you have a 50% win rate, you can expect 2 losing trades will occur 25% of the time (or EVERY FOUR trades). That means after your 4th coin toss (If you survive that long) you will have 2 losing trades in a row, and BLOW YOUR ACCOUNT!
Now you’re not an idiot! Obviously. So you only risk 33% of your account on each flip of the coin. Meaning you would have to lose 3 times for you to BLOW YOU ACCOUNT. If you look at the table, the probability of a 50% win rate strategy, losing 3 trades in a row is 12,5%. You can expect a 3 loss streak after about EIGHT trades (12,5% of the time)
Now already your risk of ruin is looking a bit better, right? NO! You don’t want that number anywhere near that low! You need to be somewhere between 25-50 trades before you BLOW UP.
How do we do that?? Reduce the percentage of your account that you risk on every trade. The higher your WIN RATE, or the higher your RISK vs REWARD, the less this is going to be a problem.
You need to be aware of your risk of ruin because if you ignore these numbers, you are almost guaranteed to blow your account, my friend.
Now it is time for you to calculate the probability of losing all your capital, based on the amount that you currently risk and your win percentage, then adjust your risk parameters accordingly.
Don’t bet the farm.
Don’t lose your shirt.
Cut the L.
Keep the W.