Risk of Ruin Ratio means how much probability you have of wiping out the equity in your trading account in a single trade. You should try to learn how to control the percent of capital you risk on each trade so that you have a minimal chance of being ruined. You can effectively use the risk of ruin principle to significantly improve your bottom line.
Following good money management principles is what you should learn from the very start of your trading career. Ideally you should plan for a money management system that will protect you from ruin. There are a number of ways to calculate the percent of capital you risk. These calculations require you to know what your current win ratio and payoff ratio are.
Are you maintaining a trading journal or a trading log? If not then you should because you need to have a historical record of your trading performance. You need to understand how the Risk of Ruin is calculated. The Risk of Ruin mathematical formula is based on three components. Win Ratio, this ratio is determined by your percentage of wins and your probability of wins. For example if your win ratio is 30%, it means that you have 30% winning trades and 70% losing trades.
Payoff ration can also be only calculated by looking at the past performance of your trades using the same trading system. Payoff ratio is how many dollars you earn compared to each dollar lost. Payoff Ratio is the average winning trade amount divided by average losing trade dollar amount. For example, a payoff ratio of 3 to 1 would mean that you earn three dollars for every one dollar you lose.
Now what should be the Percent of Capital Exposed to Trading? How much of your capital you should risk in each trade? If you are a novice trader it is recommended that you risk no more than 2% of your trading account value on any one trade. However, for advanced traders it is sometimes good to risk more than 2% of their equity on a single trade.
Over time you will learn the importance of improving your win ratio and the payoff ratio. Your trading system design and your skills as a trader determine the win ratio and the payoff ratio. But your money management system controls the percent of capital that should be exposed to trading. The Risk of Ruin should be carefully calculated depending on the proven historical performance statistics.
The higher the chances for the risk of ruin, the larger the percentage of capital that you risk on each trade! The risk of ruin ratio decreases as your payoff ratio increases or your probability of winning increases.
Calculating the probabilities of ruin is done through tables. You can estimate your probabilities of ruin by identifying what your payoff ratio and win ration are and by referring to the risk of ruin tables. What you need is a trading system that has a payoff ratio greater than 1 to 1.
As I said earlier start keep track of your trades in a trading log. This means that you must be tracking your trades and determining what your win ratio is and what you payoff ratio is. Now you need to determine what you personal rate of return is on your current trading system.
Let’s take some examples to illustrate how to use the Risk of Ruin (ROR) Ratio. The following are four hypothetical trading scenarios using a risk amount of 2% of your trading account on each trade. You need to evaluate what percent of your trading account should be risked on each trade to avoid the risk of ruin. These are only four examples. There can be numerous more examples by changing the different variables.
1. Suppose your capital at risk is 2%, your win ratio is 45% and your payoff ratio is 1 to 1. In this case the Risk of Ruin (ROR) is 100%. However, your ROR probability will change from 100% to something like 50% if you can reduce your capital at risk to 1% from 2%. The next thing that you need to do is to review your trading system to improve your payoff ratio to at least 1.5. This will bring your probability of ruin to zero.
2. Suppose your capital at risk is again 2%, your win ratio is 35% and your payoff ratio is 2 to 1. In this case, Risk of Ruin probability is 16%. However, your ROR probability will change from 16% to almost zero just by decreasing your percent of capital at risk.
3. Suppose your capital at risk is 2%, your win ratio is 25% and your payoff ratio is 3 to 1. In this case your Risk of Ruin probability is 19%. However, you should have observed that your win ratio of 25% is too low. Try to make it better. You need to review your trading system and increase it to at least 30%. This reduces the ROR probability to almost zero.
4. Suppose you have 2% of your capital at risk, your win ratio is 50% and your payoff ratio is 3 to 1. In this case, your Risk of Ruin probability is almost zero. You should note that these are the statistics for an advanced trader. In this case you could risk 10% of your capital and still maintain 0.2% risk of ruin.
For example, if your win ratio drops to 35% be sure to adjust the percent of your account you have at risk. The last figures are for expert traders only. Remember to change your trade size if your performance statistics dramatically change when you reach this level.
So both the win ratio and the payoff ratio are important. Sometimes you will need to focus on your win ratio and the number of winning trades you have. Sometimes you will have to improve your payoff ratio. Sometimes getting risk in line is as easy as reducing the percent of risk you take on each trade.
Trend trading is highly popular among the traders. No doubt about it. If you can identify a trend in its early stage and ride it till its end, the profit potential is great. If you are a trend trader, just staying in a profitable trend longer can boost your bottom line. Giving attention to your exit points may enable you to significantly improve your payoff ratio.
Now these were the Risk of Ruin probability figures. There is another formula that you can use. This formula is known as the, “Optimal f Formula”. It is used to calculate the optimal fraction of capital to be risked. The figures that you will calculate using this formula will be more aggressive than the Risk of Ruin tables.
Use this formula f= [(A+1) x p-1]/A to calculate the optimal fraction f to be risked on each trade. f is the optimal fraction to be risked on each trade in this formula. A is the average payoff ratio or the dollars earned to each dollar lost and p is the average win ratio. This formula gives more aggressive figures so use it with caution.