Option Investor
Trader's Corner

Risk of Ruin

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It never fails. When I tell people that I am a writer but make my money trading, someone compares my career as a trader to that of a gambler. I chafe at such comparisons. I'm a technical trader, I want to assert. I employ indicator systems that are complicated enough that I gain the same pride I used to gain when working with Fourier series in college.

But do traders have anything to learn from gamblers?

You bet they do. The first lesson is that traders can lose their shirts, better known as their trading capital. Dare I say it? This is particularly true for options traders who must bet on both direction and timing. These traders, more than anyone else, need to employ two strategies to protect trading capital: determining the appropriate size of their bets or positions and setting appropriate stops.

The risk of blowing through trading accounts has a name we can borrow from the betting world: risk of ruin. Let's be honest when addressing the risk of ruin. If the term is given its strictest interpretation for traders, that of blowing through a trading account, the risk of ruin is greater for those with small trading accounts. Why? Drawdowns.

Drawdowns occur when a trading plan suffers a number of losses in a row, an inevitable event, no matter what the trading style or system. Add in the costs of commissions and slippage, and it's not a hard concept to grasp that a series of losing trades is going to run through small accounts faster than it's going to run through larger ones, even if traders with the smaller accounts are entering smaller position sizes. The costs of commissions and slippage are going to represent a larger percentage of their trading capital, adding to the risk of ruin.

That series of losses happens to all of traders. The better traders are and the better their systems, the less the likelihood of the drawdowns being too deep or prolonged, but make no mistake. They happen to everyone. Even a system that produces 90 percent winning trades over a long period of time will occasionally suffer short periods of one losing trade after another, and only a few people can claim a system that produces 90 percent winning trades. Most systems produce fewer winning trades. Traders with small accounts run the risk of paper trading or backtesting a new system, verifying that it works, only to have that inevitable series of drawdowns begin to occur once real money is at risk in real positions.

This is a risk that all traders must accept. It's the reason brokerages make traders agree that trading is risky before they'll take their money and open accounts. Recognize that it can happen because that recognition makes traders more realistic about the amount that they should devote to a particular position and also helps control some of the shame of a losing trade. Or several in a row. No system is 100 percent.

So what is the optimum amount that should be risked on each trade for those traders with a $5,000 account or those with a $100,000 one? You're not going to like my answer because I'm going to tell you that there is no one right answer. Google "risk of ruin" and you'll find a number of online calculators put up by betting sites that will chug out a percentage number. I suggest that you try them to get a feeling for how quickly your trading capital can be depleted if positions represent too high a percentage of your trading capital. All traders should have an absolute feeling for what can happen if they invest too much in positions and hit one of those inevitable periods of one losing play after another. However, while you're gaining some understanding of how this works and attempting to optimize your position sizes, as I absolutely believe you should attempt to do, be aware that these calculations require some assumed inputs and also that they're leaving out something important. A couple of somethings important.

Those inputs include the relationship of the loss traders will accept to the profit they seek and the probability that each trade will be profitable. For example, in the November 2006 issue of STOCKS & COMMODITIES, Lee Leibfarth ("Measuring Risk") computes the risk of ruin for a system that produces a 50 percent likelihood of a trade being profitable, actually a rather high percentage when many profitable trading systems produce winners only 40 percent of the time. This system works on a 2:1 profit/loss ratio. The stop is set at half the value of the profit limit, the profit number at which the system automatically takes a profit. In other words, imagine that you want to make a $2.00 profit on each options trade and so will set your stop at a $1.00 loss for each. Your position is either automatically closed with a $2.00 profit or a $1.00 loss. This system determined that the optimum percentage of the account to be risked on each trade was a rather high 25 percent, not a percentage that I would ever suggest for our readers.

If you haven't guessed already, Leibfarth points out that this was based on a coin-toss system and that in this idealized system that gambles on a heads-up successful outcome, no accounting was made of the costs of commissions and slippage. Fortunately, no one charges us yet to toss a coin and calculate successful outcomes, but in the real world of trading, those commissions and slippage costs would eat into the profit. Trades would no longer produce the 2:1 profit/loss relationship. Even this optimum 25-percent position risk in the coin-toss test resulted in a 20 percent risk of ruin, however, without those extra commission and slippage costs. The risk would have been higher without them.

At www.traderscalm.com, a writer employs the same 50 percent winners/losers coin-toss methodology to calculate risk of ruin. The writer starts with $100 and calculates the risk of ruin if $1.00 were bet on each toss of the coin and then compares that to the risk of ruin if $10.00 were bet on each toss of the coin. The risk of ruin for those betting $1.00, or 1 percent, on each bet turns out to be less than the chance of winning a lottery--a very low risk of ruin--since the wrong outcome would have to occur 99 times in a row for ruin to occur. Before options traders with small accounts are tempted to decide they'll just keep their position sizes at 1 percent, though, I hasten to add some cautions. First, some might decide to keep their position sizes at such a low percentage by buying far-out-of-the-money options. I regularly hear from traders who have bought such options. The reason I hear from them is that those options aren't increasing in price enough with each movement of the underlying to make them profitable by the time they pay part of the bid/ask spread to buy them and give up part of the bid/ask spread to sell them and then pay commissions for both trades on top of that. Far-out-of-the-money options feature extremely low deltas, the measure of how much the option's price will move as the underlying does. A 1-percent position size may not solve the problems incurred by traders with small accounts, not if they must seek low-delta options to keep positions at that size. Even if these traders are finding some options with reasonable deltas, their profits may not be enough to pay for their commissions and slippage costs because the profits are so limited by the small position size. Leibfarth's calculations also found that risk of ruin rises when position sizes are too small because profits don't accrue quickly enough to build up a cushion against the inevitable periods of several losing trades in a row. Something higher than 1 percent may be necessary.

In the TradersCalm example, the risk of ruin for those betting $10.00 on each throw of the coin was 1 in 1,000. If $7.00 is thrown bet on each throw, the betting account could weather 14 tails in a row. I have to caution here that, again, no commission or slippage costs were included, and those would change the risk of ruin because they change the profit/loss ratio that was established at the beginning. It's no longer 2:1. Still, the profits would build a bit faster and the costs of commissions and slippage wouldn't eat into them as fast.

Perhaps traders will find, after making these calculations on the online sites that offer calculators (TradersCalm doesn't, at least not that I can find), an optimum position size that feels right for them, realizing that the risk is never zero unless the coin is never thrown and the bet is never made. Something else must be considered. It is also important to realize that, even if traders have calculated that their trading account could weather the drawdown that would occur with 14 bad outcomes in a row or even 20 or 40, something might start happening along about the seventh or eighth or twenty-first loss in a row. Emotions might kick in and start getting in the way. In a real-life situation, traders might be tempted to alter the size of their positions or engage in more or less risky trades with different profitability ratios. They might vary from their trading plans.

TradersCalm calls that last response the trader-emotional-response risk. Some might find that risk too high for certain trading styles, requiring them to adopt trading styles that are more in tune with their personalities so that they incur less trader-emotional-response risk. The risk of ruin is not cut-and-dried, as many calculations as we make and as much as we'd like it to be. When traders are assessing risk of ruin and trying to determine an appropriate position size and type of trading, they have to know something about their emotions and trading personalities, too. We can't rely on these coin-toss analogies alone to decide on position size.

For example, some well-known traders and market gurus have determined in the past that break-out plays tend to be more profitable over the long run, but the drawback to such plays is that the proportion of winning plays to losing plays can be much lower than in other types of trading systems. Long strings of losing plays in a row can occur as breakouts appear to be occurring, only to have a quick reversal happen. The overall profitability depends on having an account large enough to weather the drawdowns, on keeping losses on each losing play small in relationship to the sometimes significant gains when a breakout play runs a long distance and on managing the emotions that arise in dealing with those prolonged drawdowns.

There's another pesky problem: even if traders carefully calculate risk of ruin, market conditions can change and the calculations no longer work because profitability ratios have changed. There's a possible solution for this. Another suggested method of managing risk is to employ two different trading styles, each with different risk profiles, but with the requirement that one tends to be profitable while the other might be experiencing a period of drawdowns. In more complicated terms, they should have a negative correlation with each other. For example, a trading style that benefits from breakout plays might be combined with one that benefits from range-bound trading, the old buy-low-sell-high type. When the range-bound trades are souring, markets are likely trending, which means the breakout plays might be performing well, and vice versa. This method of managing risk of ruin requires some complicated decision making when deciding how much of an account will be devoted to each type of play, and it means that the emotional risks might rise if some trades are always losing. Traders who suffer the most shame when trades are losing will find it difficult to employ such a methodology.

A third method of managing risk is termed the anti-Martingale method, and it's one that I have been employing for the last eighteen months. Explained simply, traders using the anti-Martingale method would increase the size of their positions as their trading system produced profits. This can backfire, as the size of trades can be increased just as a period of losing trades and the inevitable drawdowns set in, but the anti-Martingale method helps to manage that difficult-to-quantify risk, the trader-emotional-response risk. That emotional response can heighten as the number of options contracts escalates. Accustoming oneself slowly to increasing position sizes can help manage that risk. Traders who are accustomed to trading well with five contracts at a time might not do so well if they deposited a hefty amount in their trading accounts and decided to trade fifty contracts at a time. Having fifty contracts appear to go wrong at one time could lead to a panicked decision, one not in keeping with the trading plan. Traders might bail before either the profit limit or the stop was hit, for example. The anti-Martingale method would suggest that traders would scale up gradually from five to fifty contracts, lowering that trader-emotional-response risk.

The www.traderscalm.com website offers ideas for managing trader-emotional-response risk as well as ideas for position sizing. All traders should remain aware of these basic maxims: risking too high a percentage of one's trading account on each trade increases the risk of ruin but risking too little can do that, too, as this method will not build enough profit to pay for the costs of commissions and slippage or weather drawdowns. The smaller the trading account, the more vigilant traders must be about position size, keeping losses small in relationship to gains and managing that trader-emotional-risk. Stops must be used and losses managed, no matter what the size of the account, because the size of losses in comparison to profits is an important input in calculating risk of ruin. The risk of ruin can not be reduced to zero by micro-sizing the size of positions or even by vigilantly setting stops, but it can be managed.

This may sound pessimistic, but it can be reassuring, too. If you've ever blown through a small account, it might not be the fault of your trading style or your acumen as a trader. Of course, your system itself may have been faulty, and that's something you should examine, but also you may simply have been using too large or too small a position size, heightening your risk of ruin. You may have simply had bad luck in the timing of inevitable losing plays, a fact you can accept if you think about all this in a purely mathematical way and realize that the risk of ruin is never zero. That doesn't get you off the hook from thinking about the issues related to risk, however, and it doesn't absolve traders with big accounts from employing sane account-management practices. While a larger account may be able to better weather drawdowns, it's going to hurt a whole lot more if you run through that account. Ask me. I know some people who have run through big accounts.

Google "risk of ruin" and try out some of those online calculators. Get a feel for the way that changing position size and the profit/loss ratio might change the risk of ruin, given the proportion of profitable trades you think you're producing. Check out some of the ideas at TradersCalm for managing that traders-emotional-response risk.

One caution. Some portions of the TradersCalm site lead me to suspect that following links may result in a pitch to serve as a trading coach. I haven't followed all the links so I can't be sure, and the site says all services are free, but enjoy the free portions and think long and hard before seeking and paying for a trading coach, if following a link should result in that offer.
 

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