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Understanding Risk Of Ruin.
Lot of times, we try to be successful and try to hit a home run and we get out or miss out on smaller opportunity and end up losing. Now logically if you turn the scenario on its head, and start thinking that we want to lose everything, we might end up hitting the home run.
Perry Kauffman developed this theory of Risk of Ruin exactly on these principles.
The risk or ruin (also known as the probability of ruin) is the probability that you will lose sufficient trading capital that you deem it impossible or unwise to continue trading. This point does not need to be bankruptcy (it often is) but is where you throw in the trading towel and close your trading account.
What is the PROBABILITY?
If you pursue any occupation or endeavor for long enough you may witness events that are once-in-a-lifetime or at least very rare events. A bird watcher, may for example, rarely if ever see an Spoon-billed Sandpipers on Michigan Lake. However, the chances of him/her seeing an Spoon-billed Sandpipers increase the more bird watching he/she does.
Trading is no different. If you pursue a trading career for long enough and you execute a sufficiently large number of trades you will most likely see long losing and wining periods. The longer you expose yourself to trading the more likely you are to see those extreme events.
Perry Kauffman considers the following 2 premises:
- In real trading, once profits accumulate, the chance of ruin decreases. The greatest risk is at the beginning.
- If we plan to withdraw profits, thereby maintaining the same relative commitment to the market then the risk of ruin must be greater than if we accumulate profits and keep the trading position the same.
Kaufman gives us the following formula for calculating the risk of ruin:
risk_of_ruin = ((1 – Edge)/(1 + Edge)) ^ Capital_Units
Edge is the probability of a win.
We can see that the mechanics of the formula are such that the larger the value of Edge the lower will be the risk of ruin. This is also intuitively logical because the greater your edge in any strategy the more likely you will have more winning trades. Also, the greater the number of capital units employed the lower the risk of ruin. Again this should be obvious: The smaller the amount you risk for any one trade relative to your capital base the lower the risk of ruin.
Risk greatest at the beginning why?
As mentioned above, the risk of ruin is greatest at the beginning.
One reason is because your capital base is smallest at this point and if you immediately hit a string of losses it will take a smaller string of losses to wipe out your account
There is another reason why risk might be greatest at the beginning. This may be because of lack of experience. An experienced trader who has survived for a long time will have overcome losing habits that a new trader may still have. These losses may be from simple things such as not operating the trading platform correctly to more complex discretionary decisions about when to override the system.
Conclusion
The risk of ruin is greatest at the beginning. The risk of ruin also increases the longer your remain a trader because the risk of experiencing a series of losses increases.
When one hits a losing streak, or when market is not behaving the correct way, by scaling to smaller trade sizes as the portfolio is reduced one lowers the risk of ruin and improve the survival rate.
Hence for new traders, they should really think about how much they want to risk, once they start making a bit, then increase the risk appropriately. Starting with 0.5% of total portfolio risk and then increasing it by 0.10% is a very prudent way to start.
