T2W Trading Community

What Is The Risk Of Ruin?
Please excuse me if I start off a little technical in this article. There is nothing complicated about the risk of ruin concept but it does require a quick calculation.

Simply stated, the risk of ruin is the percentage probability that a trader’s account balance will reach zero. This will either result in the trader ceasing to speculate on the financial markets, or having to stump up another chunk of capital in an attempt to make back the first tranche before making net profits.

Having a solid trading strategy which is applied with discipline is clearly crucial, however understanding your probability of success or failure given certain actions must be more so.  By using the risk of ruin formula a trader can optimise his risk per trade to minimise the probability of going under.

Risk of ruin = ((1 - Edge) / (1 + Edge)) ^ Capital units

Where ^ denotes 'to the power of'

Edge is the percentage advantage that the trading strategy has over a randomly selected group of ‘nonsense’ trades. For example, if I place 10,000 trades and 50% of the time the market falls and 50% of the time it rises (when I thought it would rise every time) the results would show that my strategy had an edge of zero%.

However, if my predictions are accurate 51% of the time then I have an edge of 1%.

Capital units are the number of units of money that you have to risk. For example, if you have £1,000 in your trading account and risk £50 on every trade, you have a total of 20 capital units (1,000 / 50).

The Risk Per Trade
The most important thing to consider in calculating the risk of ruin for your trading is your ‘edge’. If your edge is zero and your trades are no better than darts thrown at a financial newspaper by a monkey then you should not trade at all. Assuming however that you are able to make at least slightly intelligent decisions it should be greater than zero.

Let us conservatively assume the hypothetical case of a trader with a 5% edge over randomness. The chart below shows the probability of depleting his account to zero assuming a range of units of capital from 1 unit to 100.

As the number of units of capital increases, the probability of losing all of the funds in his account decreases towards zero.

What this means in practical terms is that one should sub divide one’s account into anything up to 100 individual units of capital and risk no more than one unit per trade.

How And Where To Trade
A trader with £1,000 at his disposal should, if being conservative, risk no more than £10 on each transaction. This may seem like a very small amount but don’t worry. By following a good strategy you will increase your capital at a solid rate until you have many times more money and are trading in far larger size.

As risking smaller amounts (such as £10 or £20 per trade) is not feasible through the mainstream brokers I would advocate starting off with the greater leverage and lower risk that fixed odds financial betting offers.

As you increase your edge, you can reduce the number of units of capital you need because (see chart below) a more skilled trader with a better edge has a far lower probability of ruin. This means that each trade will be bigger and in turn lead to greater profits.