Tag Archives | position size

Risk of Ruin. An Unpleasant Topic for Traders

This post recently appeared at OptionsZone.com, where I am a contributor.  Take a look at Options Zone – you will discover options articles of interest.

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For some, investing is a necessary evil.  Such investors don't want to be bothered, and often hire professionals to handle their investment decisions.  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. 

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.

There are many reasons why the majority cannot succeed as traders.  The obvious is that not everyone has the required skills.  It takes an education, the ability to understand what's required, and a special skill set to be a surgeon, professional athlete, or novelist.  The profession of trading has similar entry points.  The problem is that few believe that to be true. 

They 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.  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.

Trading looks easy.  You buy, and then sell at a higher price.  Or perhaps you sell short, and then buy at a lower price.  What's so difficult about that?  Those TV ads of the 1990s technology bubble convinced many that it's a cinch to get rich in a hurry.

Today's post is not about the requirements 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 make all the difference. 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.

Definition

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 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.


Philosophy

RoR calculators are designed for people who take frequent risk-taking chances.  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.  The first item in the list is often the killer.  Trading with too little money makes it difficult to succeed.

The following increase the risk of ruin:

  • The size of your initial bankroll decreases
  • Trade size increases
  • Trade frequency increases
  • Your win rate decreases; 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.

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 of 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 glad to have a risk of ruin that's 'only' 3%?  Or would you consider that to be far more risk than you can afford?

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.

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Equivalent Positions: Do You Know Your True Position?

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Position Size: When Is it Safe to Increase?

Mark,

You
bring up an interesting point about increasing position size. You
mention increasing to two kites with a max of 20-lot of iron condors. But assume
that you don't use kites to protect against excessive moves, and
prefer covering part of the position to reduce risk.

By how much of an
increment would you recommend increasing your position size if you're
used to trading 10 lots? And once you've become comfortable with the new
size, how frequently would you consider increasing size again and by
how much? This assumes limited capital constraints — within reason of
course.


Thanks,

Burt

***

Owning insurance allows a minor size adjustment.  But it's minor.  Insurance does not guarantee that you will not incur losses.  If you trade without insurance – as most do – size increase can only occur when it is justified.

My basic philosophy of trading is involved with this answer.  There's more of that philosophy in Lessons of a Lifetime.  I caution you to find a trading philosophy that suits you, and not blindly follow my suggestions.  The reply below is based on my comfort zone and experience.

1) Do not increase position size until you believe you understand how to manage risk for the strategy (or strategies) being traded.

2) Be certain that you get the nuances of the strategy and that you are comfortable with your positions and confident that you can earn money using these methods.

3) As a side issue:  Most people who trade have no idea that the average result for people who try to become short-term traders is to lose money.  That's the average result.  Most never become profitable.

I don't know how true that statistic is for us.  As option spreaders, we hold positions longer than the short-term trader.  Our success does not come from reading short-term trends.  It comes from managing risk efficiently and adopting methods that are appropriate for our psychological needs.   I suspect than earning any reasonable profit represents an above average result.

4) Before you even think about increasing size, you must be profitable.  Comfortably profitable.  Only you can determine what that means, but it does not mean earning $50 per month, after expenses. You must be able to see your account value increasing.  If you are withdrawing money for living expenses, then it's especially important not to increase size and jeopardize a significant portion of your account.

Although it may not be easy to determine, I'd want to know that profit did not result only from good luck, but instead was based on action taken or decisions made.

5) You must have faced several risk management decisions and handled them effectively.  If it all went smoothly and you had no pressure and no tough decisions, you have no method for measuring your skills.  I know that a string of profits is encouraging, but it is not enough to begin trading larger size.

What's a good decision?  It's not that the 'adjustment' made lots of money. It is knowing that the decision accomplished your risk management objectives:  it reduced risk, it resulted in your owning a position that met your needs and fit within your comfort zone.  It means you did not take defensive action just to do something.  It means that you wanted to own the newly adjusted positions and did not own it because it was 'the best' you could do. Furthermore, it means that additional handling of the position was done carefully and intelligently.

6) If you pass those tests, next comes your comfort zone.  Try a 20% increase and trade 12 iron condors, and remain at that level for several months.  When you believe you are ready to move to larger size again, repeat the entire process. 

Carefully examine what has been happening.  Do not rely on 'profits' as the sole factor that determines how well you are progressing.  Examine the same questions you tackled earlier.  If you do not find proof that you are handling the positions skillfully, do not increase size.

Yes, that advice is easy to ignore when you are making money.  But if you cannot prove to yourself that you have been skillful, rather than lucky, trading larger size will make things more difficult.

7)  Here's the problem:  If the market is kind to iron condor traders – as it is part of the time – you can get lulled into a false sense of confidence and when it hits the fan, you may have too much size to handle comfortably.   It's really easy to lose a year's worth of gains in a hurry – especially when trading too much size.

8) Don't ignore the size of your account.  I note that your question does take this into consideration.  But overconfidence can bring big trouble.

If your account value is not growing steadily, then it's too soon to increase size. No matter how much you decide to risk on a specific trade, it must never be large enough to jeopardize your being able to stay in business – if something terrible happens.  And it will happen – if you trade long enough.  You can own insurance to offset the major part of the problem, but that's not a cheap fix.

653


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Position Size: A Matter of Life and Death (for a Trader)

Mark,

This is
what I've been considering (Conversation started earlier). I figure the kites provide great protection
if the Iron Condors don't behave, yet they reduce the premium of an IC
significantly.  The risk is minimal but so is the profit.

So if I exited both the kite and the 10-lot of Iron Condors at the same time – for say
only $300 profit, it wouldn't be enough for me. However, if I put on 10
times as many I would have approx $3000 profit ,which is more acceptable. Thoughts?

Joe


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You may be too young to remember Lost in Space, a TV show from the mid-1960s, but one line from that show comes to mind:

Danger_will_robinson_

1) It requires 10k margin to do a 10-lot (of 10-point iron condors).

It requires 100k of available margin to increase size by 10 times and trade a 100-lot.

If you earn $300 when risking $10,000 that is no different from earning $3,000 when risking $100,000.

2) The risk graph looks nicer.  And it is nicer.  Perhaps it's 'nicer' by enough for you to move from 10 to 12 iron condors.  But to move to 100?  No way.

It is not that safe.  It is just safer.  And the final safety is going to depend on skills as a risk manager.  Do you have enough confidence in those skills to up position size by an order of magnitude?

3) I  hope that you are suggesting, or at least asking about, increasing position size by a factor of 10 because you are new to the options world. 

I would tremble at the thought of an experienced trader asking this question.

Increasing position size by anything except a small increment is fraught with danger.  First, you don't know how you will react if and when trouble looms.  Second, you may be risking almost your entire account on a single trade.  You just cannot do that and expect to survive. 

It's unlikely you would lose anything resembling the maximum 100k (yes, this is possible, depending on strikes chosen), but how can you afford to take that chance?  Would you be able to exit a trade to lock in a $20,000 loss if you judged the position too risky to hold?  If you cannot do that, you will become frozen and unable to take needed action.

4) Look at your risk graph the day prior to expiration.  Note how those kites have gone from a 'rescue plan' to a potential disaster.

I know you 'plan' to exit prior to expiration, but many times traders are just unwilling to pay the necessary cost to exit.

5) I agree that you may indeed do nicely with this concept.  But all it takes is one bad situation – guaranteed to occur (but who knows when?) and you may be permanently out of business.

Please do not do this.  If you get some practice with the 10-lots, and demonstrate a good ability to handle risk for a minimum of six months, then I would consider – and I mean consider (not automatically doing it), moving size up to where you buy two kites instead of one.  Under no circumstances can that be more than 20-lots of an IC, and I think that's too large of a jump in size.

One more point: When I said 'demonstrate ability to handle risk,' If you have six easy wins with no serious adjustment decisions, that does not count.  I am referring to situations in which you face serious decisions and make a good choice each time. I am referring to having the courage to do the right thing and not taking on too much risk just because you are frozen with indecision.  If you can do that a few times – then and only then can you consider yourself experienced enough to move up (gradually) in size.

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