The risk of ruin is an important calculation for option traders.
To be rewarded, you need to take risks as a trader. The more risk you take, the more rewards you can get, but the more you can lose.
Nobody wants to go broke.
This article looks at a measure of risk called the Risk of Ruin.
We will define it and discuss its usefulness as a measure of risk.
Risk of ruin is the likelihood that a trader will lose significant amounts of money until he is broke or unable to recover from losses.
The formula helps traders quantify a probability for this worst case scenario.
The risk of a ruinous formula calculation is as follows:
((1 – (B – L)) / (1 + (W – L))) U
W = the probability of a successful trade.
L = the probability of a loss.
U = the maximum number of trades until bankruptcy (or ruin is reached)
One of the main reasons Risk of Ruin matters is that just having the odds in your favor is not enough.
Without proper risk management, it is possible that you could go broke despite good trades.
Let’s look at the table below. Imagine a 60% win rate.
With over 100 incidents, it is a guarantee that you will lose at least 3 times in a row.
There is also a 1% chance that you will lose 10 times in a row!
In our formula for the risk of ruin, note that we are different variables.
The difficulty with all games that don’t have fixed odds, like the stock market, is that we have to compute a value as if it were fixed.
Let’s imagine we have a 60% probability, but in reality our strategy is a dud. It turns out we only have a 40% chance.
Instead of a 1% chance of losing 10 times in a row, we now have a 42% chance.
Not only that, the chances are that in 100 trades we will almost certainly lose 6 times in a row!
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While calculating these odds can be difficult, having a larger data set can help us determine what normal drawdowns are and when to reevaluate the strategy.
However, it is common for good strategies to have drawdowns mathematically they become rarer as the size of the drawdown increases.
** tip **
When calculating values without a lot of data, be conservative with your numbers.
Remember that you are trading against the market.
The market is generally very intelligent.
Handling your numbers conservatively can help ensure that you don’t get caught off guard.
After you have more data, you can always adjust the values upwards.
Of course, the question of whether you should aim for a risk of ruin of 0 is generally answered with yes.
That being said, the real answer is, it depends.
The Risk of Ruin formula calculates ruin as the inability to return.
Although mathematicians sometimes go overboard.
In most cases, bankruptcy, or financial ruin, is not equivalent to death. If a young investor loses it all on $ 1,000, it most likely isn’t the end of the world.
After all, they can still get a job at McDonalds.
In fact, risking 0.01% randomly on a $ 1000 account can be a lot worse for this young investor.
They used the opportunity costs of their time and had nothing to show for it.
Conversely a long term Investors approaching retirement should definitely have a 0 risk of ruin.
You are dependent on the money saved in your job and have no interest or will no longer be physically able to work.
In fact, the risk of ruin for this investor can be so low that they will lose 25% of their account.
Of course, individual preferences also play a role here.
Maybe I’m a younger investor, but I can’t stand the slightest risk of going broke.
In this case, it makes sense to forego returns for a mindset.
However, it is important to remember that there is no return without risk.
Likewise, the opposite gambling mentality will ruin a trader before they know it.
While under bets are bad in the long run, over bets are fatal.
At this point, realizing how lucky it is to invest may seem derogatory.
However, there are many ways to reduce your risk other than simply betting smaller.
These strategies reduce your risk of ruin far more than the formula predicts.
The first is to vary your bet size based on your edge, rather than simply having a fixed bet size on each trade.
Define your advantage and bet accordingly.
Taking greater risk for some trades may seem like a risk-seeking act, but it is exactly the opposite of when the payouts and probabilities increase, the risk of ruin decreases.
The second is when you lose, you bet smaller.
This is the opposite of what many investors do. Double or bet more increases the risk of ruin.
Betting less can take longer to recover from a drawdown, but at least you will.
Finally, placing diversified trades.
When the success of one trade is correlated with the failure of another trade, much of the risk of each trade has been hedged. Conversely, placing 100 short straddles on all of the components of the Nasdaq may seem varied when in reality it is just a bet on the Nasdaq itself.
It is important to measure the risk of a catastrophic drawdown. It may seem better to keep these things out of sight and out of mind.
Unfortunately, ignorance on the stock market is only a godsend for so long.
Using Risk to Ruin can be a probability a worst-case scenario and provide information on when the risk is too high or too low.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.