Many traders focus on finding the right trading strategy and don’t give importance to money management. But once you gain experience in markets you will realize that even with a mediocre trading strategy once can make consistent profits if they have sound money management rules. Often people blow up their trading account in spite of having a good trading system because they end up risking more with every trade.
Many experts suggest you risk 2% per trade. But many beginners usually risk anywhere between 5% to 10% per trade. There are certain systems which have higher winning accuracy and higher risk reward ratio as well. With such a system risking only 2% per trade won’t yield significant returns, we can risk more on such systems. So finding the correct risk per trade is very crucial which can make or break your trading system. If you can find the optimal risk per trade in a trading system, then your chance of blowing up the account goes down drastically. We can use the risk of ruin calculator to find the optimal risk per trade.
What is risk of ruin?
Risk of ruin is the probability that an individual will lose substantial amounts of money through trading—to the point where it is no longer possible to recover the losses or continue.
Consider you are following a trend following trading system which usually has 40% winning accuracy with risk reward ratio of 1:2
If I am risking 5% of my capital on each trade, then there is a 23% chance that my drawdown can go beyond 40%. This denotes that I am risking much higher with each trade. I should keep my risk of ruin as low as possible.
So let’s reduce the risk per trade from 5% to 1.5% and check what’s my risk of ruin? Now with 1.5% risk per trade, my chance of facing a 40% drawdown is reduced drastically which is just 0.76%. By keeping my risk per trade at 1.5% , my chance of blowing up the account or facing a huge drawdown has gone down where I have less than 1% chance of risk of ruin.
You can use this calculator https://fxjake.com/risk/ and give your input parameters of your trading system to find the optimal risk per trade.
- Prob. win denotes winning % of your system.
- Reward/Loss ratio denotes your risk reward ratio. Average profit in winning trades divided by Avg loss in losing trades gives you the RR ratio
- Risk amt(%) denotes the risk per trade of the trading system. Choose your risk per trade you want to allocate with your system
- Number of periods – you can enter 1000 or 2000 trades here
- Loss level % – type your maximum risk you are willing to take with your capital.
Irrespective of what your trading system says about draw down, always calculate your risk of ruin which will give you the correct statistical answer on choosing the optimal risk per trade. Do not randomly decide your risk per trade %.