The market is a risky and uncertain place.
Of course, this probably won’t prevent you from being attracted to it and from wanting to trade it.
And, for good reason — in general, hiding under your bed to avoid risky decisions is not an ideal way to live life. What’s more, we all know that risk can also imply opportunity. So, risk is not always a bad thing.
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Life as a whole, just like the market, is inherently risky. Hence, at every turn, we’re continually weighing the costs and benefits of every decision we make.
In some sense, we’re all risk analysts whether we’re traders or not.
But there’s a major problem: most of us aren’t actually that good at this. And it’s part of the reason why most people don’t do well in trading.
As a trader (and risk manager), I’ve made my fair share of mistakes in terms of risk assessment, risk management, and risk taking. So, in this post, I’d like to briefly explore a few important concepts related to risk that I wish I knew a few years back when I decided I wanted to be a trader.
Those concepts, if understood, will help you deal with risk more sensibly and intelligently.
1. Knowing The Odds
Part of evaluating whether risk taking is appropriate is knowing the probability or odds of something happening.
Probability is the chance something will happen and it’s a number from zero percent to a 100 percent – zero percent means an impossibility and 100 percent means a sure thing.
In an endeavor like trading, you can hardly get an exact probabilistic number regarding a potential move in the market or even a trade outcome through the use of technical analysis. The uncertainty level is too high and most technical traders arrive only at an intuitive assessment of probabilities.
Daniel Kahneman (The economist, noble prize winner, and author of Thinking Fast and Slow) and his friend Amos Tversky spent their entire careers studying how humans actually estimate probabilities.
They found that, in general, people tend to overstate the likelihood of rare events occurring while underestimating the chance common events will happen. They also tend to overvalue certainty.
In other words, we’re wired to look for patterns and we tend to see them where there aren’t any.
In no place is this more glaring than in the market. Newer traders like to indulge in the illusion that they can explain and anticipate anything and everything using some fancy indicators or their uncanny chart reading skills.
But it’s not that simple. Yes, you can learn to better assess probabilities (intuitively), but this intuition gets refined over time, with experience and practice.
What’s more, at first, you’re likely to make a lot of mistakes and get “fooled by Randomness”, as Nassim Taleb so aptly puts it.
And finally, even with countless of hours of studying the market, you’re unlikely to become a prophet – remember, the uncertain level is quite high in trading and no amount of analysis or skill will change that.
Hence, pro traders, focus more on managing risk (the effect of uncertainty on objectives) rather than obsessively making high probability predictions.
Knowing The Cost and Payoff
This is the other part of evaluating risk – knowing the cost and the payoff.
The issue is that the payoff isn’t always obvious because different traders might decide to book their profits differently.
Some have a fixed target; others decide to have a moving one depending on the circumstances; some others choose not to have any target at all and instead let the market do its thing.
All methods of approaching the Payoff part are valid, and it’s perfectly reasonable to choose something that works best for you provided that you keep it consistent and do your best to book bigger profits than losses on average.
Speaking of losses (cost), this is the part you need to keep under control.
Absolutely!
Kahneman and Tversky also found that we tend to place greater value on a dollar we lose than on a dollar we gain.
The particular pain from having money taken away is called loss aversion and it creates the tendency to remove a stop loss for fear of actually booking the loss – when the trade is still open, we can still dream and fantasize about recuperating the losses.
This bias (loss aversion) plays a huge role in trading and it’s the reason most people go burst and fail to make any money at all.
Here are 5 possible outcomes for your trades:
- Small payoffs
- Big payoffs
- Breakeven
- Small costs
- Big costs
By all means, eliminate the big costs (losses).
If you can manage to do that while remaining in the game (you want to keep playing it) and booking bigger profits than losses on average, your account will grow. Despite some few small losses here and there.
Is that a guarantee?
Over enough trades, YES!
The Importance of Expected value
Okay so, to recap, in trading (and more broadly, in life), part of evaluating each risky situation is knowing how likely it is that something will happen.
That’s the odds.
And just as important is to know the potential risk (cost) if something goes wrong and the potential payoff if something goes well.
That’s the cost and payoff potential.
When you have those numbers, you can then figure out the “expected value” of a situation.
The expected value is the odds of something positive happening multiplied by the payoff + the odds of something negative happening multiplied by the cost.
EV= {%W * $W} + {%L * $L}
And this tells you whether a particular decision (or set of decisions) will yield a positive outcome or not in the long run.
In the long run is the key word here.
Expected value is closely linked to the law of large numbers which states that events with uncertain outcomes have the property that no particular outcome is known in advance; however, over the long run, the outcomes occur with a specific frequency.
Expected value is very important because when making all kinds of important decisions in life, ideally you would want those decisions to work in your favor.
This means that even if the decision(s) result(s) in a negative outcome in the short term, if you make such decision(s) over and over again in the future, you’ll end up with a net positive outcome.
So, ideally, you want to know if your approach to trading (your system, process, strategy, or whatever you want to call it) has a positive expected value.
If it does, then no matter what the short term results look like, over the long run, if you keep playing, you will build massive amounts of wealth.
Conclusion
So, when trading, you need to keep in mind not only the odds but also the cost and payoff, and, of course, the expected value.
Every trader needs to understand how much risk they can take on any individual trade; how much risk they are prepared to take in the achievement of their goals; how much risk is too much risk, etc., etc.
The problem with newer traders is that they don’t understand these different concepts that are directly related to risk; hence, they can’t set proper risk thresholds.
If you can’t set proper thresholds, you can’t win at this game – if you do happen to win in spite of that, then it’s pure luck… take the money and run, my friend… don’t try to rinse and repeat.
I just briefly explored those ideas. If you want to learn more, I recommend the following books:
Nassim Taleb’s Incerto Collection.
Probability for Dummies by Deborah Rumsey
Daniel Kahnman’s Thinking Fast and Slow.
As another option, if you want to learn probabilities with me very simply, check out the Trading Psychology Mastery Course. There’s a whole module dedicated to thinking in probabilities.