One of the most immediate strategies for avoiding situations of this kind is to build a
barrier, a protective wall that avoids the consequences of the risk of ruin on personal assets. Many people compromise their economic serenity because they have not adequately considered their exposure to financial ruin, concentrating their attention only on possible future earnings from trading, whereas what distinguishes the professional trader from the neophyte is precisely the ability to control this type of risk.
Contrary to popular belief, traders are not unscrupulous risk-takers; the greatest speculators are individuals who have a significant aversion to risk and are often unsurpassed in their management of risk. The best thing to do, therefore, is to start with a calculation of the trader's personal assets, making an estimate of the value of all assets, both movable and immovable.
Having done so, it is recognised as rational, logical and prudent to allocate NO MORE THAN 10% of total assets to trading. Basically, if we imagine an asset value equivalent to 100, the first target is to protect 90% from the risk of ruin, in the sense that this is the portion that should never be exceeded whatever the result of activity on the markets, even the most negative.
The remaining 10% may well represent the working capital available for trading, which many also refer to as business capital. It will be the maximum loss even in the event of a catastrophic outcome of our trading, whether on traditional or virtual markets, a level that if affected should force us to abandon all financial activity.
After that, at each moment, i.e. at each trading-related time fraction (day, week, month), one should only invest a predefined portion of the so-called business capital, which expresses the amount of money available to be transferred to the trading platforms or an exchange. Operating capital therefore also means the margin required by the broker, if leverage is used, or the total position, if leverage is not used, plus the maximum loss calculated for the period.
In addition, from a production point of view, the retail trader should distinguish the socalled certain sources of income from the random ones. In concrete terms, it is a good rule to separate trading profits from the more secure ones, such as employment income, rental income, coupons from fixed income financial assets, deposit accounts, etc., as it is almost always crucial to be clear in mind that these two different types of income sources can coexist, while it would be very compromising to have as the only source from which to draw money that coming from trading.
Even in 2019, there is no private trader in the world who is able to support himself solely on the proceeds of market activity. Even the individual who earns consistently and persistently sets aside a portion of his profits, which he invests in less risky assets that provide him with additional, safe capital gains.
Conversely, a trader who does not have sufficient capital to ensure an appropriate income stream without significant risk will have to work, whether he wants to or not, until his economic situation is such that he can leave his job.
In other words, one should never give up one's job for trading, not least because one does not work just for the money. As a matter of fact, until the returns equal or exceed the income from work, it is advisable to continue working in the traditional way.
On the subject of risk exposure and the so-called risk of ruin, let us finally consider the law of statistical ruin. This is the first fatal mistake a beginner trader can make. In short, if you lose 50% of your initial capital of $100 , you are left with $50 (100 -(100*50/100) = 50). However, if you start with $50 and gain back the same percentage that you lost - 50% - you will end up with $75 (50 + (50*50/100) = 75).
The law of statistical ruin, in practice, shows that the possibility of recovering the initial value of lost capital is inversely proportional to the loss. To better understand the concept, an excel table is available in the figure that relates the initial loss of operating capital to the recovery needed to restore the initial capital.
Comparing the percentages of initial capital loss with the percentages required for recovery demonstrates the absolute necessity of rational money management, which takes into account a considered risk-return ratio in all trading operations.