Money Management: Risk of Ruin

Written by anjinito

Hello traders,

Your weapon in trading is your cash, and whatever you do, you should always think of risk first and then about profits to preserve cash.

But what happens in trading when emotions are coming into play?

• Too much money is put at risk to get a relative small profit
• Stop losses are widened when a trader is wrong and does not want to close the trade
• Too many trades are taken even the less promising ones

Trading and getting an edge is pure mathematics. If you are going to win or lose over the long term depends on the following:

Payoff ratio

This is the average profit per trade divided by the average loss per trade. The higher the payoff ratio, the better. So if you have a profit of $200 against an average loss of $100 then you have a payoff ratio of 2:1.

Win ratio %

How much % of the trades do you close with a profit

Risk of Ruin

Let us say that you risk 10% of your capital and you have a win ratio of 50% and a payoff ratio of 1:1. Then you have a chance of 99% that you will blow up your account (Risk of Ruin). If your win ratio goes up to 60% and the rest stays the same then your risk of ruin is 1.70%.

Getting your payoff ratio from 1:1 to 2:1 or even higher is more difficult than just getting your win ratio up. You will have to stay longer in a trade, so you will have to catch more pips to increase your payoff ratio and that is difficult.

(You can look up risk of ruin tables on the internet)

So to make sure you do not have too much draw down it is better to risk less % of your account per trade so that you can stay in the market and with risking less you make sure that one ore more losses do not damage your account beyond repair.

So % risked per trade, win ratio %, payoff ratio are important parameters to monitor and also for the trader to try to improve. Currently on eToro you can find the win ratio %. But like I explained that does not tell the whole story.

Best regards

Anjinito

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