2nd Skies Trading

Risk of Ruin Calculator

Result

Risk of ruin:

If you’re not familiar with Risk of Ruin and how it’s calculated, scroll down.

How would you like to know in one statistic whether you are going to make money or blow up your account?

Yep, that’s right, with one trading statistic you can find out which of these two paths you’re going down. It’s called Risk of Ruin (RoR), a statistic that is crucial to know if you’re serious about making money in trading.

For example, let’s say you are risking 10% of your capital per trade, have a 2:1 reward to risk ratio per trade (R:R) and an accuracy rate of 35%. Did you know that based on these numbers you have a 60.8% probability of losing all your trading capital?

Is this something you would want to know ahead of time? I hope so.

History of the Risk of Ruin Model

The mathematics of the Risk of Ruin tables were first applied to gambling and rightfully so. In gambling, say blackjack, if you win a hand with the dealer busting, you get a 1-1 payout so if you put $100 on the hand, you will win $100. It helps to know this ahead of time so you can see if your edge (% chance you will win over time) is enough to make money or lose money.

However, this is the tricky part. In trading, we rarely know exactly how much we are going to make per trade in terms of profit. However, we do have an entry and a stop loss, so we are aware of our risk and potential profit.

But here is the harbinger and some questions to consider:

  1. How many times have you closed a winning trade before hitting your full profit target?
  2. Do you have a trading system where the profit target is the exact same for each trade and therefore you know what your exact payout will be if you hit your target?
  3. Do you know exactly how accurate you are going to be with your trading based on the system you use? In other words, have you modeled it so you can predict its overall accuracy within a few % each month?

If the answer to question 1 is around 25% or greater, then we will need to take this into serious consideration when calculating our risk of ruin.

If the answer to question 2 is no, then you will need to favor this in when calculating your risk of ruin.

If the answer to question 3 is no, then the answer is the same as above and it’s likely the mathematics are working completely against you.

Let’s explore each question, then do the math and see what a stable level of risk is so you can keep your account growing.

Closing a Winning Trade Before Hitting Full Target

If you’re still learning how to trade, let’s be honest and ask a critical question. How many times have you closed a winning trade before hitting the full target?

If you were perfect in your discipline, never made an error in trading and risk management, then I would say go ahead and risk 10% of your capital every time if you could ensure that you’re always trading with 40% accuracy and had a reward to risk ratio of 2:1. If you did this, you would only have a 14.3% chance of losing all your capital and likely have a strong positive trading performance.

However, if you are cutting your winners short, say 50% of the time and you cut them in half every time, then with the same level of accuracy, your risk of ruin goes up to about 60%, meaning you have a 60% chance of losing all your capital.

This changes the game completely and puts the mathematics heavily against you having a long trading career. In fact, every time you shorten your original profit target, you stack the numbers against you.

Now ask yourself what is more likely. Are you more likely to…

  • cut your winning trades short by closing them early before hitting your take profit, or…
  • extend your targets and thereby increase your profits?

If you are more likely to cut your winners short, this means you have to decrease the amount of risk per trade to keep the same mathematical edge.

A ‘fixed-profit’ trading system

Even if you were using only one system, chances are, it does not have a fixed target.

The reason why having a fixed target gives you an edge (mathematically) is because once you can stabilize the accuracy ratio, you can easily calculate your risk of ruin because your risk and reward is fixed from the outset. This makes the math very ‘tidy’.

However, having a fixed target may not always be advisable. Sometimes the market will make a big run/move, and instead of exiting at a predefined target, taking advantage of those big moves when they come and ride the momentum until it comes to an end is a wiser choice.
Catching bigger moves increases the alpha (the rate of return on an instrument more than what would be predicted by an equilibrium model) on your returns and helps smooth out losing periods.

To give you a different perspective, if your trading system on average is 50% accurate, your average risk to reward ratio is 2:1, you should be making $1000 on every win and $500 on every loss.

After 10 trades you will have banked $2500 of profit. However, if you have an alpha of 5%, you will make an extra $125 which over time adds up.

Accuracy

Unless you have done massive forward and backtesting on your system, you won’t know the exact answer to this question. On top of this, markets change, and your accuracy levels will likely fluctuate with them.

One question to ask yourself is, do you know your current accuracy ratio for all your trades?

If you do not, then it is highly likely you will have the numbers stacked against you, and your chance of losing all your capital is more likely than you think.

To be on the safe side of things, you want to have a smaller amount of % equity at risk per trade. This also becomes more critical in the early stages of your trading where you are likely to make more mistakes, have a lower equity ratio and take profit before hitting your full profit target.

Now that we have gone over this, to give you a quick idea about the risk of ruin, the table below shows you the probability of losing all your money in % based on your average payoff- and win ratio risking 1% per trade.

Risk of Ruin Chart

Let’s briefly deconstruct this.

Using 1% of capital at risk per trade, if you are 25% accurate and have a reward to risk ratio of 3:1, you have a 51.7% chance of losing all your capital.

However, if you can increase your edge (accuracy) by only 5%, you decrease the risk of losing your entire account to 0%. This shows the power of increasing accuracy ratio in order to lower your risk of ruin and increase your overall edge in the market.

Now, let’s take the same accuracy ratio of 25% but increase the reward to risk ratio to 4:1 from 3:1. This again turns your 51.7% risk of ruin to 0%, increasing your edge tremendously.

Now, here’s the challenge. In trading, it is harder to increase the profit target from 3:1 to 4:1 compared to increasing your accuracy ratio by 5%.

5% in accuracy is not a big shift. 10-20% is a big shift and much harder to achieve, but 5% is not.

This means that over a series of 100 trades, you only need to increase the # of winning trades by 5.

Now let’s take the other side of this equation. Let’s say you are 35% accurate and have a 2:1 reward to risk ratio. You will only have an 0.7% chance of losing all your capital. However, if you start cutting your winners, so your average reward to risk goes down to 1:1, how does this change the mathematics? It turns your Risk of Ruin from 0.7% to 100%!

So, by starting to cut your winning trades early, now you have a 100% chance of losing all your capital. Does this help you to see how critical it is to always review your trading performance and keep an eye on your risk of ruin?

Of course, things happen that can make it difficult to be not only perfect in our discipline, but also perfect in our mathematics and R:R ratios. It is simple if we are trading blackjack where we know the fixed profits we can make and lose, but this is not blackjack – it is a fluid living breathing market and sometimes it would be advisable to exit early. Does this increase your edge or reduce it? More than likely, any adjustments to your trading system and reward to risk ratios decrease your edge, not increase them.

What does this mean for you?

Put the edge so far in your favor that it is almost inconceivable you would lose all your capital. If you have capital, you are in the game but if you don’t, you are out. Your capital is your ammunition and without it, you’re dead in this game.

This is especially true if you’re still learning to trade consistently. Even if you are a good trader, you’d want to keep your risk/trade low because over time, you will inevitably be running into losing periods, every trader does. And when you do, you want to absorb the losing streaks well and not give away big chunks out of your account.

Although it may not seem like you will make a lot of money risking 1% and having a 2:1 reward to risk ratio, over time as your account grows, it will compound, and you will take losses with ease of stride.

However, by risking more, you severely alter the mathematics and your edge. And far worse, you increase the psychological pressure to recover the losses which further compounds the emotional/mental energies against you.

If your R:R ratio is 2:1 or better, when you lose, you will lose a little and when you win you win much more. Even if you take a series of losses, it will only take just as many wins to be back ahead.

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