This is the second post in a series of posts I’ll be making about trading.  It seems everyone and their grandmother is trading stocks and Bitcoin these days, so I figured I put out some info to help some newbies learn about the markets.

In this post, my focus is on the concept of risk of ruin.

In gambling, risk of ruin refers to the possibility that you will lose all of your money due to a string of losses.  Suppose, for example, we are playing a coin flip game where every time we flip heads we win $2 for every $1 bet, and every time we flip tails, we lose $1.

The odds suggest that after four flips, we should be up $2, because we should have two winning flips and two losing flips.  With that in mind, if you had $10 in your pocket, how much would you bet on each flip?

Even though the odds of the game are in our favor, there is still a chance we can lose all of our money.  For instance, if you had $10 and bet $5 each time, you only need to lose on your first two flips and you are out of money.

There is actually a 25% probability of this happening on your first two flips.

It should be noted that the larger the bet size, the greater the risk of ruin.  In fact, risk of ruin increases disproportionately to the increase in bet size.

For instance, doubling the size of the bet will not just double the risk of ruin…it will increase the risk by triple, quadruple or even more, depending upon the particulars of the game or system being played.

Professional Money Managers and Risk Management

Risk of ruin is one of the key considerations of professional traders when they develop trading strategies.  This is particularly true among fund managers who participate in the futures markets and other markets where significant leverage may be employed.

Trading legend Monroe Trout was one of the most risk-averse traders in the world of futures trading.  The main reason Trout was such a legend was that he was able to generate substantial returns with very little volatility.

The reason his funds experienced such low volatility was because he was not willing to risk nearly as much of his equity on any given trade compared to most other professional traders.

Trout employed far less leverage in his trading because he discovered that the risk of a black swan type of event, such as the 2008 financial crisis, was much greater than what most people thought.  He actual wrote his thesis about this concept while studying at Harvard.

This is why it is critical that you never risk too much of your equity on any given trade.  You just never know when a poor earnings report or other news event may have a substantial negative impact on any one of your trading positions.

With all of the volatility we are seeing in the markets these days, understanding the concept of risk of ruin is more important than ever.

If you have any questions or comments, please comment below.  If you found this post informative, please share.

Thanks for reading!