A trader\'s money management system

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Using Risk-of-Ruin Tables and the OptimalfFormula 79

You will find blank trade posting cards and ledgers that will be useful

for this purpose in Appendix B. For details on how to use these forms see

Chapter 13, which shows you how to calculate the statistics you will need.

AFTER YOU RUN THE NUMBERS

After you run the numbers on your current rate of return, you will need to

evaluate what percent of your trading account should be risked on each

trade to avoid the risk of ruin. Here are four hypothetical trading scenarios

using a risk amount of 2 percent of your trading account on each trade (the

following risk of ruin calculations for a 2, 1.5, and 1 percent risk amount

come from Tushar Chande’s book,Beyond Technical Analysis, 2nd ed.,

page 288):

1. Win ratio 45 percent, payoff ratio 1 to 1, with 2 percent at risk,
   ROR probability is 100 percent.In this case, you could reduce the
   percent of capital risked from 2 percent to 1 percent and your ROR
   probability would change from 100.0 percent likely chance of ruin to
   52.4 percent—almost half. Your next goal would be to review your trad-
   ing system to improve your payoff ratio to at least 1.5 which would
   bring your probability of ruin to 0.


2. Win ratio 35 percent, payoff ratio 2 to 1, with 2 percent at risk,
   ROR probability is 16 percent.This example shows more stable
   numbers than the first example so just by reducing the percent of cap-
   ital risked from 2 percent to 1 percent on each trade your ROR proba-
   bility would change from 16.0 percent to 0.1 percent—nearly 0.


3. Win ratio 25 percent, payoff ratio 3 to 1, with 2 percent at risk,
   ROR probability is 19.7 percent.Here, your win ratio is too low,
   and your first goal is to raise it to 30 percent, which would allow you
   to risk 2 percent of your capital on each trade and would reduce your
   ROR probability to 0.0 percent.


4. Win ratio 50 percent, payoff ratio 3 to 1, with 2 percent at risk
   ROR probability is 0.0 percent.These are statistics of an advanced
   trader, and as such you could risk 10 percent of your trading account
   on a trade and maintain a 0.2 percent risk of ruin (see Table 9.1). Re-
   member, when you reach this level, be sure to reduce your trade size if
   your performance statistics dramatically change. For example, if your
   win ratio drops to 35 percent, be sure to adjust the percentage of your
   account you have at risk.
   These four examples give you a start and show you how to use the
   grids in the ROR tables to learn where you want to focus your energy to