Meaning
- A Ruin Problem is one where there is a chance(however small) that an outcome will result in an unrecoverable loss.
- Eg: Think of a gambler with $ 1,000 doubling down every time he or she loses a bet. Lose $ 5, bet $ 10. Lose $ 10, bet $ 20. Such a strategy, known as a martingale, will inevitably lead to gambler’s ruin
Not all Losses are Ruin Problems
- In the gambler example, if he has unlimited resources, martingale will eventually pay off.
Why Ruin Problems Must be Considered Seriously
- If there is even a slightest risk of ruin associated with an action, the probability of ending up in a ruin becomes certain as you increase the number of attempts at it.
“Because the ‘cost’ of ruin is effectively infinite, cost-benefit analysis… is no longer a useful paradigm..When the harm is infinite, the product of any non- zero probability and the harm is also infinite.. The potential harm is so substantial that everything else in the equation ceases to matter. In this case, we must do everything we can to avoid the catastrophe.“
The Precautionary Principle
Case of Short Volatility Strategies
- The Strategy:
- In Short Volatility strategies, you sell far Out of the Money options for pennies.
- Since the underlying wont reach the sold strike price more often than not, you make a steady income most of the days.
- Essentially, the strategy is akin to selling insurance for a catastrophic event for a tiny premium.
- If you do this long enough eventually, the catastrophe will materialize and you’ll end up in ruin if the exposure is significant enough.
- Example: LJM Partners
- The fund made money selling OTM Put Options on the S&P 500.
- Years of low interest rates(2012-2017) had led investors to engage in large short volatility strategies, driven by regular returns from selling volatility using futures contracts
- In Feb 2018, due to the Volmageddon Incident, LJM Partners lost 80% of its fund value in 2 days and ended up shutting shop.