A number of people have attempted to apply the idea of Gambler’s ruin to Forex day trading. Whether you can accurately apply the idea of gambler’s ruin to Forex trading is questionable, but if such an application is relevant it appears to undermine or at least make it more difficult or improbable to be a successful Forex day trader.
The term Gambler’s ruin is a term used for a number of different statistical ideas. But when we mention in regards to Forex we are taking to mean a particular idea namely that:
‘a gambler with finite wealth, playing a fair game (that is, each bet has expected value zero to both sides) will eventually go broke against an opponent with infinite wealth.[or much greater wealth]'(From Wikipedia)
What is meant by a fair game? Well a fair game for example would be a game of head or tails using a fair coin. Each person has a 50-50 chance of winning each time the coin is flipped. People have tried to equivocate that Forex trading is roughly a fair game, for example it shares a number of features. For example each position entered into can either go one or the other way and we cannot determine with certainty before hand which way a position will go. Secondly, its taken that a small day trader is taking on another opponent namely the rest of the market each time he takes a position. It also stated that all the information which could influence an individual into opening a position is available to everyone.
If we accept all of this it appears that a trader who is poorly capitalized is likely to go bust in the long run if hes competing in a fair game against better capitalized traders. For, example if we suppose that two people are going to flip a coin for infinite number of times, each with a fixed bet of 10 Cents. Further suppose Player 1 (the poorly capitalized day trader) has $100 while Player 2 (a big investment bank) has $1,000,000. It is far more likely that the better capitalized player will end up all of the money, even if it does take an extended number of coin flips to eliminate Player 1 from the game. It is almost impossible for Player 2 to ever be eliminated from the game, so the chances are that eventually the Player 2 will end up with all the money.
How does Forex differ from the Gambler’s Ruin analogy
- Firstly, bets (position size) aren’t fixed and many money management systems empathize scaling in and out of positions.
- Secondly, whether the analogy of the rest of the opposing market being an opponent like the person your flipping a coin against works is questionable.
- Thirdly, and probably most importantly the analogy of Forex being a fair game seems flawed. Many traders say that you can get an advantage on other market players by being better informed, having undertaken more research or have a unique insight.
All of these points seem to seriously undermine the gambler’s ruin analogy. As it appears that those who apply the gambler’s ruin to Forex market are applying a situation which doesn’t quite fit the complex and dynamic nature of the international Forex markets.
Can we take anything from such an Example
Yes, I believe we can take one important things from the gambler’s ruin analogy. I think what the analogy brings to the table is the difficulty of taking on better capitalized opponents in the field of the financial markets. As they have much better ability to absorb a prolonged period of losses. It is no wonder many of the most profitable proprietary Forex trading desks are some of the biggest in terms of capitalization.