Risk of Ruin is the basis of the most money management systems. Risk of Ruin has been extensively studied by the mathematicians and the traders. Know candlestick charting.Learn swing trading. First practice on your forex demo account.
You can effectively use the risk of ruin principle to significantly improve your bottom line. You should try to learn how to control the percent of capital you risk on each trade so that you have a minimal chance of being ruined.
There are a number of ways to calculate the percent of capital you risk. These calculations require you to know what your current win ratio and payoff ratio are. Ideally you should plan for a money management system that will protect you from ruin.
You need to understand how the Risk of Ruin is calculated. The Risk of Ruin mathematical formula is based on three components. Win Ratio, this ratio is determined by your percentage of wins and your probability of wins. For example if your win ratio is 30%, it means that you have 30% winning trades and 70% losing trades.
Payoff Ratio is the average winning trade amount divided by average losing trade dollar amount. Payoff ratio is how many dollars you earn compared to each dollar lost. For example, a payoff ratio of 3 to 1 would mean that you earn three dollars for every one dollar you lose.
Percent of Capital Exposed to Trading. How much of your capital you should risk in each trade? If you are a novice trader it is recommended that you risk no more than 2% of your trading account value on any one trade. However, for advanced traders it is sometimes good to risk more than 2% of their equity on a single trade.
However, this amount should be carefully calculated depending on the proven historical performance statistics. Your trading system design and your skills as a trader determine the win ratio and the payoff ratio. But your money management system controls the percent of capital that should be exposed to trading.
The risk of ruin ratio decreases as your payoff ratio increases or your probability of winning increases. The larger the percentage of capital that you risk on each trade, the higher the chances for the risk of ruin.
What you need is a trading system that has a payoff ration greater than 1 to 1. You can estimate your probabilities of ruin are by identifying what your payoff ratio and win ration are and by referring to the risk of ruin tables.
You need to determine what you personal rate of return is on your current trading system. This means that you must be tracking your trades and determining what your win ratio is and what you payoff ratio is.
You can determine what percent of your trading account, you should risk on each trade to avoid the risk of ruin. This is important. Read Part II of this article.