Every trader wants to know about the risk of ruin. This is a very crucial aspect that all traders must know about because it’s the hard-earned money that’s at stake. Risk of ruin refers to the chance of losing a significant part of or the entire balance. Calculation of risk of ruin should be easy since all traders know about their win/loss ratio and also the average size of their winning and losing positions? However, it isn’t that simple.
That said, it is crucial to know this concept. Moreover, it is also necessary to know how to calculate the risk of ruin. Therefore, we decided to help our readers know all about this crucial part of trading. In this article, we are going to explain the risk of ruin, and calculators, and also explain how to avoid it. So, grab a cup of coffee and read carefully. Let’s begin!
Risk of ruin defined
Risk of ruin refers to the probability of a trader or investor losing all his/her original capital without any recovery chances. Traders calculate it by using three factors – the probability of making a return on investment (ROI), the probability of making a loss, and the proportion of capital at stake.
Risk of ruin explained
So, what is the risk of ruin? Let’s try to understand it in the simplest words. The term “ruin” refers to an outcome in which someone loses everything because of an event. It makes you lose everything that you had earned until that unfortunate event. That also means that such a catastrophic event also makes all previous successful outcomes irrelevant. That said, it is an important factor to consider for all traders despite the fact that it happens rarely.
As we know, the risk of ruin is a very unfortunate and devastating case as it makes you lose a part of the entire capital. That means it leads you to bankruptcy. Therefore, it is absolutely imperative to do everything possible to avoid meeting the point of no return.
A considerable peril in trading
The risk of ruin is a major peril in trading and yet numerous traders have an almost negligible understanding of it. Therefore, it is important to examine its dangers.
The risk of ruin is seriously threatening for traders as it leads to a point where traders can no longer continue trading. It has caused numerous traders to lose their entire capital. However, it is important to note that it doesn’t necessarily mean that losing entire capital is the risk of ruin. Rather it depends on personal risk tolerance that varies among traders. That means, its psychological effects also affect traders and force them to quit trading without making any gains.
So, how can you combat the dangers of risk of ruin? You can combat this by learning how to calculate the risk of ruin as well as how to avoid it.
How to calculate the risk of ruin?
There are two popular methods to calculate your ruin. You can use either of the two methods as both of them are reliable.
The first method to calculate ruin is by using Kaufman’s formula. Perry J. Kaufman proposed this formula in his widely popular book Smarter Trading. His formula is;
Risk of Ruin = [(1 – Edge) ÷ (1 + Edge)]u
Edge = win% – loss%
Win% = Your win ratio
Loss% = Your loss ratio
U = The maximum number of risks you can take before reaching your threshold for ruin
Let’s try to understand Kaufman’s formula method using an example. Suppose that your trading capital is $10,000 and win% is 70% while loss% is 50%. Now, how will you calculate your ruin? Let’s say that you want to calculate ruin and that you might lose 30% of your capital. Losing 30% of your capital means losing $3,000.
Now, the first step to calculating your risk of ruin is to calculate U. You can calculate it by using the risk you take on every trade. Let’s suppose that you take a risk of $200 on each trade. Therefore, you have a total of 15 risks ($3000/$200) before losing $3,000. Now, you have all the figures to calculate your ruin.
Risk of Ruin = [(1 – 0.20) ÷ (1 + 0.20)]^15 = 5.19%
Edge = 0.70 – 0.50 = 0.20
Ralph Vince formula
The second method is considered more advanced as Ralph Vince proposed an improved formula. It eliminates the shortcomings of Kaufman’s method. Therefore, Ralph’s formula is more complicated but it gives more accurate results. The formula is;
Risk of Ruin = [(1- P) ÷ P] ^ Maximum Risk ÷ A
Where P = 0.5 × [(1 + Z) ÷ A]
Z = (win% × average win%) – (loss% × average loss%)
A = [win% × (average win%)^2 – loss% × (average loss%)^2]^0.5
Average win% = Average winner ($) ÷ Initial capital
Average loss% = Average loser ($) ÷ Initial capital
Are these methods perfect?
No, both methods to calculate the risk of ruin aren’t perfect. Kaufman’s method does not consider your average winner and an average loser. It only uses your win% and loss %. It is the major shortcoming of this method as winners are often bigger than losers. That difference greatly affects your ruin.
Ralph Vince’s method is a better option to calculate ruin. However, it is still not a perfect one as it doesn’t consider variances traders have in their trading. For example, it takes into account a fixed risk/reward ratio, win%, and lose%. In reality, those factors don’t remain constant and vary from time to time. Furthermore, this method also assumes that your trading capital remains constant over time. This is also highly unlikely as you might withdraw your capital from time to time and that change in the capital also changes your ruin.
Are there any reliable calculators for risk of ruin calculation?
Yes, there are multiple online calculators that can help you calculate your ruin with ease. You just need to have data to use a calculator. For example, you need win rate%, average profit/loss, risk per trade, number of trades, etc. to calculate your ruin. However, it is important to note that there are numerous online calculators and each one may ask for different variables. You can choose a calculator that best meets your requirements. Additionally, you can also fine-tune your trading systems using such calculators by calculating a number of possible outcomes.
Is it a good idea to use a calculator to calculate ruin? Yes, it is a good idea because using automatic tools is always helpful for traders. Such tools help them better understand the particulars that affect the trading accounts of traders. Additionally, these tools come with user-friendly interfaces and are also easy to use. That means all traders can use them irrespective of their skills and experience. Finally, automatic tools also offer more reliable and accurate results as compared to manual calculations. Simply put, using modern technology to your advantage is always the best idea as it saves your efforts and time.
Why is it vital to know about your risk of ruin?
All traders definitely aspire to make money and don’t want to lose significant sums of their capital. Yet most traders neglect the importance of analyzing trading performance and finding areas they can or need to improve. Similarly, a few traders only direct their efforts to knowing the risk of ruin. They underestimate the importance of knowing how likely it is that they will lose a major portion of their capital.
Knowing the risk of ruin puts traders on the right path. For example, if you determine that your ruin is high, you can direct your efforts to better risk management and money management. Similarly, if your ruin is appropriate, you can realistically expect your chances of making money in the future. Moreover, knowing your chances of losing all your capital also helps you stand firm during the drawdown period. Thus, it gives you the much-needed strength to stick to your trading plan.
Another great advantage of knowing your risk of ruin is that you can take appropriate measures to avoid a high risk of ruin. For example, you can limit your position size, set a stop-loss, and so on. It also enables you to trade for a long period of time by saving your capital. Contrarily, those who neglect this key aspect often find themselves on the wrong end. In short, knowing your ruin risk is absolutely vital in your trading endeavor.
Tips to reduce ruin risk
Here are a few tips to reduce your risk of ruin.
1. Using an appropriate account size
Using an appropriate account size is the key to reducing your ruin. Why so? Because having insufficient funds in your account significantly increases your ruin risk. The situation gets worse when a low account balance is coupled with leverage. Therefore, it is important to increase trading capital or reduce position size to reduce your risk of ruin.
2. Reducing position size
Reducing position size is also integral to reducing your ruin. It reduces ruin risks because putting less capital at risk means ruin will take more losing trades. As having more losing trades is highly unlikely, it decreases the chances of complete destruction of your capital.
3. Improving trading strategies
Improving trading strategies leads you to have more winning trades. More winning trades than losing trades means increasing your average winner and reducing the chances of ruin.
4. Analyzing your trading performance
Analyzing your trading performance is also crucial. For example, you can analyze a losing trade and find out what went wrong. Thus, you can fix those issues. Moreover, you can also think about avoiding trades with higher losing probabilities. In this way, you can decrease losers and improve your winning ratio.