“I have two basic rules about winning in trading as well as in life.
- If you don’t bet, you can’t win 2.
- If you lose all your chips, you can’t bet.”
- Larry Hite
In trading, there are only two components in your control. The first is pulling the trigger i.e. entering a trade, and the second is knowing your risk in advance. Unfortunately, a majority of traders try to control the uncontrollable (the outcome of a trade) and in their quest to control the uncontrollable they forget to control the controllable (risk).
Successful trading is really all about successful risk management. To survive as a trader, you will need to look at your business of trading as a business of risk management. Good traders are good risk managers. This is the difference between the winners and the losers. They respect what the market can do to them, they understand that it’s a losers’ game, they strive to be the best loser, and their objective is to manage their risk capital with modest expectations. Their whole focus is survival, and that depends on their success at being good risk managers.
If you want to trade, you’ll need to approach your task from a risk manager’s perspective; and leave the trading profit bias to the punters.
First you need to know your risk of ruin.
READ MORE: 3 key ways to maintain a risk-adjusted portfolio
What is the risk of ruin?
Risk of ruin refers to the chance that you’ll lose so much money that you’ll stop trading. It’s not necessarily losing your entire account but it could be 40 per cent, 60 per cent or 100 per cent at times. Hence your first priority should be to avoid risk of ruin. If you can manage to do that then you may stay afloat for a longer duration in your trading career.
How do you calculate your risk of ruin?
Let’s say there are two traders, A & B, and both are using a trading system which has a 55 per cent winning probability. They both start with an initial capital of Rs.1,00,000/- each. Trader A is an aggressive kind of trader, he decides to risk Rs.10,000/- per trade, hence his risk of ruin is Rs. 1,00,000/10,000= 10 trades.
At this point, I’d like to tell you that a system with a 55 percent win rate can easily have ten losing trades in a row and in this case when it does, it means you have lost your entire capital.
On the other hand, Trader B is a conservative trader, and he decides to risk only Rs. 5000/- per trade so accordingly his risk of ruin is 1,00,000/5000= 20 trades, which means it will take 20 consecutive losing trades for his capital to be wiped out. Though this can be possible but it has a much lower probability.
READ MORE: How to manage risk: Striking the right balance
So you see Trader B by reducing his risk to Rs. 5000 has provided himself with 20 trading opportunities when compared with Trader A who has 10 trading opportunities. In this way, Trader B has reduced his risk of ruin as compared with Trader A.
Therefore, in order to avoid risk of ruin, firstly you calculate the probability of your chances of reaching there. If the probability is too high then you need to lower it. How do you do that? You simply need to lower down the percentage risk that you are willing to take per trade.
E.g. If your trading capital is Rs. 10,00,000/- and if you decide to risk 1 percent of your capital (Rs. 10,00,000/-) per trade which is Rs. 10,000, so your risk of ruin works out as follows:
Rs. 10,00,000/Rs. 10,000 = 100 units which means it will take you 100 losing trades in a row to wipe out your entire capital. The probability of such an event happening is lower than a Black Swan event, wouldn’t you agree?
Similarly, if you risk 0.5 per cent of your capital per trade then the math works out as follows:
Rs. 10,00,000/Rs. 5,000 = 200 units it will take you 200 losing trades in a row to wipe out your entire capital. Is it possible?
So, you see, the lower you risk the longer the probability of survival.
In the above example I have shown that if you lose in 100 or 200 consecutive trades that’s when you get wiped out. But let’s not forget that you are bound to have fewer winning trades, if not many, and that further enhances your trading lifeline.
Which leads us to the question what percentage should the risk of ruin be? Well, simply put the lower the better, some of the ways to lower your risk of ruin to the least possible level is as follows:
First is by reducing your amount you risk per trade, secondly by having a trading system which has a high win rate probability and thirdly, is by letting your profits run and cutting your losses, which in terms will lead to a higher Risk: Reward ratio.
READ MORE: Capital Asset Pricing Model: How does it measure risk?
How much risk is too much or too less?
I come across many traders who risk one per cent or more. The first rule is to always prefer to have a lower risk, simply because we do not know whether the trade will be a winning trade or a losing trade. The general perception is to risk one percent of your capital.
I personally find that to be too high. I generally start with a lower risk of less than 0.5 per cent and once the trade starts moving in my favor, it is only then that I start pyramiding and increase my risk gradually.
Now that you have understood how to calculate the risk of ruin, the next step is position sizing. (To be continued in the next column.)
Follow the entire series here.
Kirit Manral is a professional trader, and has been running a mentorship program in trading since 2019, with mentees from around the globe. He can be found on Twitter at @KiritManral