Not the most inviting of titles but reality means that risking capital in trading has downside risks as well as upside potential.

Why do we trade?

Simple question; simple answer. To make a profit and to grow our capital.

However, the more serious investor wants to preserve his capital and one of the most important calculations is the “bankruptcy risk”. Rarely written about, never taught!

How not to lose trading Forex

The Holy Grail? Of course, but once we can calculate our own risk of bankruptcy, we start to understand why losses have been occurring.

What is the risk of bankruptcy?

It is the probability of a situation where we lose the money funds put aside for trading and resign. It doesn’t need to be all the money on our account balance. It could be (depending on our risk tolerance) a loss of 50% or 75%. Avoiding bankruptcy risk must be our top priority as owners of an “investing business”.

Since it is better to know what you are up against, the first step is to calculate your probability of bankruptcy. If it’s high, lower it. Generally, the more capital risked for each trade, the higher the chance of a single trade wiping us out.

There is an equation (isn’t there always? Remember school) for bankruptcy risk:

BR ={ [1-(P-L)]/[1+(P-L)]}^J

P – probability of a profit

S – probability of a loss

J – the number of transaction units on the account (capital/transaction size)

With a capital balance of $10k, we use a 56%/44% ratio between probability of winning versus losing. Our capital at risk per trade is 20%, then our risk of bankruptcy is 30%. That is high and the objective is to get as close to zero as possible. This is, of course, difficult to achieve, but it is a worthwhile target.

Using this calculation through around 25 positions a useful database can be created.

How to minimize our bankruptcy risk?

  • Reduce size of transactions

    Increase system accuracy

  • Improve risk/return ratio

Dividing the capital balance into, say, twenty transaction units (capital divided by transaction size), the bankruptcy probability falls to 1%. Increasing the accuracy of our trading system by 10% will drop it to 5%.

Improving the risk reward ratio to 1.5:1 from 1:1, having a 50% accuracy and 20 transaction units will provide a bankruptcy probability close to zero.

In summary, the more risk you take the more your bankruptcy probability rises and vice versa. It is useful to continually verify this calculation as you trade to ensure that the amount of risk taken is in accordance with your overall plan.

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