The risk of ruin is the probability that a trader will lose money to the point of no return.
Timmy The Trader
To put the risk of ruin into perspective, let’s dive into the life of Timmy the trader. Timmy is your classic millennial trader, looking to get rich by diving into Youtube to search for the ultimate trading strategy. Jacked up on Mountain Dew, Timmy hits it big making over $1000 within his first day. Trading raw without protection could lead Timmy to the ultimate jackpot (you know how that ends) or it could leave him slammed by the market.
Either way, he pulls a W off and ends the night with his wife feeling like a king. The next morning Timmy wakes up and decides to trade the New York session. Feeling phenomenal from the night before, Timmy decides to take it slow by only risking 50% of his account. The worst-case scenario is breaking even (which really isn’t the worst), but choosing to risk only 50% means if Timmy wins today he’ll cash out his evening $1000 richer than he was when he woke up.
Pumped up from his previous wins, Timmy’s emotions get the best of him. The adrenaline kicks in and he decides to go in for a buy thinking there’s no way the market will continue to fall. Seconds after pulling the trigger Timmy realizes he forgot the biggest news event of the month was happening today. Instantaneously with his realization Timmy glances over at his computer and begins to watch the market bleed in front of his eyes. After doing some calculations and believing he should be fine, slowly but surely his account dwindles down to margin calls. His account drops down to $400, then $300, and by the time the trade closes, he is confronted with the big 0 following the dollar sign reading his account balance.
Just when he was beginning to make money, Timmy let his emotions get the best of him. His rush of adrenaline clouded his judgment at a time when his trading future relied on his calls. Disappointed and defeated, Timmy decides that trading isn’t for him and decides to keep gambling on the weekends for fun. At least that way he can hang out with his buddies.
Timmy isn’t necessarily a bad trader
Did I get your attention? Don’t take that story personally or think too hard about it. Every aspiring trader has been in that spot before. Also, trading can be super complicated and boring so I thought “what the hell let’s just let this one rip”. We surveyed over 1,000 traders in 2021 and found that 90% of them had little to no understanding of trade management strategies. They did know the basics, but that is about it. The basics can take you pretty far by the way. The problem is they were missing a streamlined process to take out emotions.
A lot of people have been looking at the markets for years. Sometimes they are just a few pieces of information from greatness. Timmy’s problem is clear as day and you can see it from a mile away. He has zero trade management principles in place. It is only a matter of time until he blew that account. What aspiring traders don’t understand is that phenomenal trade management can take you to the finish line with a mediocre strategy. Yes, trade management is arguably more important than trading.
So in terms of risks of ruin – it is the point that an individual will lose substantial amounts of money through investing, trading, or gambling—to the point where it is no longer possible to recover the losses or continue.
The risk of ruin formula determines a trader’s likelihood of staying alive in the markets.
The risk of ruin formula calculation is ((1 – (W – L)) / (1 + (W – L)))U
W = The probability of a winning trade.
L = The probability of a loss.
U = The maximum number of trading risks that can be taken before the trader reaches their threshold for being ruined.
The smaller the percentage of your trading capital you risk on any one trade the lower the risk of ruin.
THE BOTTOM LINE IS…..
What is your win rate?
What is your risk per trade?
What are the odds of your longest losing streak?
How wrong can you be before you hit the point of no return?
Keep in mind emotionally if you have zero statistics, zero data and are trading in the dark mentally you may have a point that causes you to act irrationally as well.
What we found to work best is know your data.