For some, investing is a necessary evil. They don’t want to be bothered with it, and often hire professionals to handle their investment decisions, according to options trading articles. Others love the idea of making trades, and if they encounter a winning streak, may seriously consider the idea of quitting their jobs and becoming full-time traders.
Trading is one of those enticing, glamorous careers. The idea of being self-employed, taking vacations whenever you want, earning tons of money — it all sounds like a dream come true.
It is a dream, but the truth is unpleasant. The average income for people who try to become full-time traders in an attempt to support themselves and their families is less than zero. In other words, it’s not that they don’t make enough money to survive as a trader; it’s that they don’t make any money. The vast majority are forced to give up the dream and go back to the real world.
There are many reasons why most cannot succeed as traders. The obvious is that not everyone has the required skills. We don’t see people trying to practice law or medicine without the proper education, training and licenses, yet many individual investors believe it cannot be difficult to trade for a living.
Hopeful traders put together a small pile of cash, make some trades and are disappointed when they realize how difficult it is. Making money is tough enough, but when trading expenses are added to the picture, the burden is too great and profits are not achievable.
And for those who do well, i.e., they do better than average and eke out a small profit, they never consider that choosing the wrong broker — one with high fees — may be more than enough to make frequent trading unprofitable. (Get 4 Tips for Picking the Right Options Broker.)
Or perhaps they go the other route and sacrifice good trade execution for low rates. Poor decisions along those lines may be enough to sink a trading career.
Today’s post is not about the requirements for becoming a professional trader per se; it’s about one simple idea that is virtually ignored by both professional and amateur traders/investors: statistics and probabilities.
Something as innocuous as being unfamiliar with statistics can be the difference between success and failure. Few traders have any understanding of this mundane mathematical science. And those who may have some passing knowledge fail to recognize how vital it is to pay attention to statistics and the lessons they teach.
Option traders may talk about probability of earning a profit for a given trade, or recognize the probability that a specific option will be in the money when expiration arrives. However, the majority have never paid any attention to, or possibly never heard about, one vital statistic: the risk of ruin.
I’ve published a list of my four important trading rules. At the head of the list is the simple command: Don’t go broke.
The problem is that I am guilty of not delving into how the trader avoids going broke. Sure I talk about managing risk and being careful with position size, but there’s more to it. It’s important to understand the risk of ruin.
Risk of Ruin
The risk of ruin, sometimes referred to as “gambler’s ruin,” is the probability of losing your entire investment account. It’s also the probability of losing so much of the account that there is too little remaining to allow you to continue trading.
There is a formula, and thus a calculator, that can be used to quantify the investor’s risk of ruin. Because gambling and investing/trading have much in common, the mathematics of the calculation are the same. The key for investors is to translate the calculator inputs from gambler’s language to investor’s language. A trusted friend has done that for us. See Dr. Brett’s description of the risk of ruin, including a link to a calculator and examples of how small changes in your approach can make a huge difference in the probability of losing everything.
This risk of ruin also applies to retirees. If you are invested and withdraw a portion of your assets every year, there is a chance of outliving your money. That’s certainly equivalent to blowing a trading account in that it’s something that must be avoided.
It’s important to pay attention to risk of ruin (RoR), but as mentioned previously, most traders have no idea that such a concept exists, let alone that it can be measured.
My Philosophy
RoR calculators are designed for people who frequently engage in risk-taking events. They are appropriate for a day trader or gambler, not for someone who travels to Las Vegas once every three years.
Applying the numbers to investors with longer time frames is more difficult. But, if you understand the concept, you can find probabilities that apply to your situation.
Subtle looking changes in your trading style can make a huge difference in the probability of ruin. In particular, the first item on the list is often the killer.
The following increase the risk of ruin:
- The size of your initial bankroll decreases
- Trade size increases
- Trade frequency increases
- Your win rate decreases (i.e., you begin to win less often)
- Your “opponent” has more money than you (in other words, his/her risk of ruin is much smaller than yours)
- Your “edge” decreases and your average profit becomes smaller
- Emotions begin to affect decisions
One reason so many trader wannabes are forced out of the game is that their initial stake (account size) is too small. Another is that they trade too often, especially when attempting to recover losses.
When investing, your opponent can be considered to be the vast sum of money collectively owned by everyone else. There’s nothing you can do about that negative feature, but you can be aware of it.
Also, if you begin trading with emotion instead of developing a plan, your edge decreases. That’s a very quick path to losing it all.
Bottom Line
Understanding the probability of going broke is a major requirement for the wannabe trader. I certainly wish I had been aware of these statistics earlier in my career.
How do you use the numbers when you get them? I have no answer to that. If you are trading with your life savings or retirement nest egg, would you be OK with a risk of ruin that’s “only” 3%? Or would you consider that to be far more risk than you can afford? You must satisfy your comfort zone.
One way to use the numbers is to see how the effect of position size (money at risk) makes a large difference in that risk of ruin. However you choose to use this statistic, my suggestion is that ignoring it is not viable if you plan to have a long career as a trader.
