This note explores the mathematical theory to solve modern gambler's

ruin problems. We establish a ruin framework and solve for the

probability of bankruptcy. We express the probability of bankruptcy
and distance parameters needed. And we also show how this relates
to other dimensions of the problem from expected time to ruin and
alteration from symmetrical up and down changes in trading
performance.

In the 18th century, Bernoulli solved the original gambler’s ruin problem.
This problem’s solution reflects that a gambler with a fair chance or an
equal gain or loss per wager, will eventually run out of gambling chips
when playing against an opponent with infinite resources (e.g., chips).
Prior to Bernoulli’s contribution, additional variations of the gambler’s
ruin problem were emerging throughout the 17th century, from famous
European quantitative scientists such as Fermat, Pascal, and Huygens.
Such special enhancement to the problem included limited and distinct
quantities of wagering chips between two opponents, or unequal
chances of winning any particular trial. In the past century, probabilists
under a different premise known as the cliff hanger problem have
reincarnated this problem[i]. Where a drunken man, who is initially a
certain number of steps from a cliff, then proceeds to take randomly
steps, either towards or away from the cliff. Applications away from
drunkards, gamblers, or both, do exist. Particularly in the realm of
biological reactions and the pathways of self growth and decay.

So in this note we apply this problem to a realistic options trading

strategy where a modern gambler, instead of gaining or losing a fixed
quantity of chips, can gain or lose a balanced exponential rate on their
chips. For example, a hypothetical strategy that can provide a 100%
return if it was successful or loses 50% if it had failed. It turns out that
this complication of the gambler’s ruin problem can be reduced to the
original ruin problem if one calibrates the absorption barrier that defines
bankruptcy.
We can connect this idea most readily to present-date option payoffs
related onto the changes in interest rates. And in an rough, low-
frequency example, we know that in the summer of 2011 the 10-year
U.S. treasury note yielded 2.8%. So we suggest that in a small
theoretical model that a year later we would have a 10-year yield that
was either 5.6%, or 1.4%. This fits our 100% or 50% change pattern,
respectively. And we know in the summer of 2012, with the 10-year
yield of the same instrument at 1.4%, we could have again modeled a
year ahead yield. This time at either 2.8%, or 0.7%. And again we
know that by this summer of 2013, the 10-year yield was 2.8%.

That was a similar empirical template that mirrors the theoretical

gambling framework we are solving for in this note. So instead of
bankruptcy equaling 0 chips, we can establish a ruin threshold that is a
portion of the original chips. Immediately below we will show this to be
defined as the “distance” equaling:

loss level = (½)distance

log½(loss level) = distance

Noting that we can reformulate distance as log(loss

level)/log(½).
Or ln(loss level)/ln(½).

For example, if we wish to establish a portfolio blow-up level of 25% of

the original chips (e.g., 75% loss in portfolio), then the distance would
be 2 trials. The first trial could halve the portfolio to 50% of the original,
and the second trial could further halve this 50% so that we are at the
level of 25% of the original. For this gambler’s ruin problem we can use
complete probability combinatorics and only need to examine a limited
combinations of gains and losses. These gains or losses are at the
end, just before bankruptcy. We will rationalize this below.

First, the ultimate wager can not be a gain and still result in a
bankruptcy; the final trial must be a loss. Second, the penultimate
wager must also be a loss. Certainly one can imagine this trial being a
gain instead. However, in order for a “bankruptcy” to occur, ultimately
any rebound at the penultimate wager towards the end has to
eventually be a loss, in order to provide the final wager. Therefore in
summary, one only needs to keep track of the final two trial
combinations.

The combinatorics therefore can be shown below, separating out the

initial trials when the numbers of gains are less than two trails. And we
combine this with the probabilities associated with the remaining trails,
which allow for the number of gains in total to be equal to or exceed
two trials. The reasoning we have is that in cases when the total
number of gains equal or exceeds two trials, then the number of losses
is equal to the reversal of that number of gains, plus the distance
number of trials. So when the gains equal two or more, then those
could be the final two trials, and there is a possibility for all of the initial
trials then equaling the distance number of losses. This component of
the combinatorial probability is something we’ll subtract out later in the
proof below.

First let’s show how the series looks, and in this example we are
distance agnostic so that we can theoretically solve the information
needed. Here are the variable definitions we will use:

p = probability of gain
q = probability of loss
= 1-p
d = distance
N = number of gains total

Individual trial combination probability = q(d+N)*pN.

And before solving the combinations, we will quickly review the basics
of multinomial expressions (see note here for quadnomials, or
intermediate level multinomials):

(n k1,k2,km) = n! / [k1! k2! … km!]

Where n is the total number of wagering trials, and km

represents the variables that are repetitive and so the
permutations do not distinguish among one another in the
ordering.

So now combinations where the number of gain(s) is less than the

distance, we solve for the specific multinomial needed for our specific
gambler’s ruin formulae:

(d + N*2 - 2)! / [(d+N-2)! N!] , if N<2

Noting that (d+N-2)+N=(d+N*2-2).

And in the remaining cases where the number of gains is greater than
the distance, we remove those specific invalid probability combinations
as we discussed further above:

(d + N*2 - 2)!/[(d+N-2)! N!] – (N*2 - 2)!/[(N-2)! N!], if N>2

Noting that (N*2 -2)=(N-2+N).

So let’s examine the initial probability series for the lowest numbers of
total gains.

q(d+0)*p0(d + 0*2 - 2)! / [(d+0-2)! 0!]

+
q(d+1)*p1(d + 1*2 - 2)! / [(d+1-2)! 1!]
+
q(d+2)*p2[(d + 2*2 - 2)! / [(d+2-2)! 2!] – (2*2 - 2)!/[(2-2)! 2!]]
+
q(d+3)*p3[(d + 3*2 - 2)! / [(d+3-2)! 3!] – (3*2 - 2)!/[(3-2)! 3!]]
+
…

Which simplifies to:

qd
+
q(d+1)*p*d
+
q(d+2)*p2[(d+2)!/[d!*2]]
+
q(d+3)*p3[(d+4)!/[(d+1)! 3!] – 4]
+
…

Or an expansive arithmetic-geometric series that approximates:

qd(1 + q*p*d + q2*p2*[(d+2)*(d+1)]/2 + q3*p3*[(d+4)*(d+3)*(d+2)]/6] +
…)
≈ qd*[1/(1-q*p*d)]
≈ qd*[1/(1-(q-q2)*d)]
≈ qd*[1/(1-q*d], if q < ½
and d is large
≈ qd/[1/pd]

This is not the method generally shown in advanced probability and

statistics books, though it provides a clearer breakout using the series
techniques familiar to advanced finance professionals. This solution to
our gambler’s ruin problem shows the familiar outcome that there is a
small non-bankruptcy probability, when the chance of a gain (i.e., p) is
greater than 50%. And the solution shows an eventual probability of
bankruptcy otherwise.

Now there are two additional wrinkles that we can examine with this
advanced gambler’s ruin problem. The first is to compute the expected
time for bankruptcy within this gambler ruin framework. And the
second is how to deal with derivative strategies that do not have an
exponential up and down move of 100% and -50%, respectively. While
the latter shows up periodically in probability literature[ii], the former
generally does not.

To solve the first problem we begin by noting that the expected time
can be solved as a probability summation of time until ruin, multiplied by
the probabilities we have above for the same term of the series. So the
probability of 0 gains times the combinations of 0 gains, plus the
probability of 1 gains times the combinations of 1 gains, plus probability
of 2 gains times the combinations of 2 gains, etc.

Also at this very initial limit, if there are no gains, then the distance itself
(i.e., d) is the smallest expected time until a gambler goes bankrupt.
And for each successive total gain, an additional two trials are
necessary: one for the gain, and an additional one to reverse that gain
prior to ruin. We know that the theoretical ratio we have between the
two trial probabilities in the series above is approximately pd. So the
expected time to ruin would equal:

[1/(1-pd)]*(d-1)+(d-1)

Do recall that d is preferably very large, so we do not need to

worry about cases such as d=1.
Now for the latter wrinkle to our ruin problem, let’s explore the financial
implications for scenarios where a trader’s strategy does not involve up
and down moves that are exponentially symmetrical. As with binomial
approximations to options pricing strategy, we can easily solve this by
adjusting the gain and loss probabilities instead[iii],[iv].

Let’s try this out with an example of the transformation. Suppose that
we have an initial 50-50 chance of exponentially gaining 75% or losing
75%, but now we want to adjust our gambler’s ruin problem to
consider a loss of 25% instead of a 75% loss. No change to the
gaining assumption of 75%. Then this would be the modified
probabilities to align the problem[v]:

p*(75%) + q*(-75%)
= 50%*(75%) + 50%*(-75%)
=0
= q’*(75%) + p’*(-25%)
= (1-p’)*(75%) + p’*(-25%)
= p’*(-100%) + 75%

So p’ would equal 75/100, or 75%, instead of the original p of

50%.

This would mean that we would neutralize our original 50-50 chance of
being +75%/-75% to being a 75-25 chance of being +75%/-75%. And
thus, this later expression would equate to proportions of changing our
50-50 chance to a +75%/-25% performance. Since each trial would
artificially amplify the results, if one were to consider a focus on the
distance to bankruptcy aspect of this problem, then they should want
to keep the actual level of the modified gains and losses in mind. This
is so that they can ensure that they reasonably still work, particularly if d
is not exceptionally large, or if the new loss assumption expands so that
the probability of gains per wager suddenly falls below 50%.
In summary, this note explores the mathematical theory to solve
modern gambler’s ruin problems. We establish a ruin framework and
solve for the probability of bankruptcy. We also show how this relates
to the expected time to bankruptcy and review the risk neutral
probabilities associated an adjustment to asymmetrical views.

[i] Mosteller, Fifty Challenging Problems in Probability, 1965, Dover

[ii] Ross, A First Course in Probability, 1998, Prentice Hall
[iii] Luenberger, Investment Science, 1998, Oxford
[iv] Hull, Options, Future, and Other Derivatives, 2000, Prentice Hall
[v] Jorion, Value at Risk, 2007, McGraw Hill