Punching Houdini and Mastering Risk

Risk is a four-letter word. However, if you plan on being a successful trader, you’ll want to develop an appreciation for what “risk” is, how it arises, and what you can do to control it as much as possible. As an industry, risk management includes over 30,000 companies and generates $6 billion in annual revenue.

One of the greatest magicians in the world was Harry Houdini. Houdini loved to create effects on the public that would make people think he had conquered the laws of physics. One of his favorite tricks was inviting big powerful men to punch him in the stomach as hard as they could. Before becoming a magician, Houdini had been an amateur boxer and claimed he had learned a way to flex his muscles so that he could absorb any blow that was thrown at him. On October 24, 1926, Houdini was resting in his dressing room after a performance when a group of students went backstage to visit him. One of the students, asked Houdini while he was resting if it was true that he could resist and absorb even the hardest blows to the abdomen. Before Houdini had a chance to respond the student began slamming his fist into Houdini’s abdomen. After being hit a few times Houdini gestured that he had had enough and stated that he had not had time to prepare.  A day later Houdini was doubled over with severe pain. His appendix had ruptured from the blows.  A few days later, on Halloween 1926, Harry Houdini died.  Risk for Houdini was what he didn’t see coming.

If you were to ask a statistician, they would tell you that risk is the threat of loss. Equally intriguing is the idea that those who understand risk usually perceive it to be an opportunity for gain.

How well do you think you understand risk?

Here’s a simple exercise you can try, open a demo account at your favorite brokerage platform.  Often these demo accounts will fund you with up to one million ‘dollars’ so you can paper trade your ideas before putting real money into the markets.

Once your demo account is open, try and lose all that money as quickly as you can.

I know it sounds silly. However, if you do this exercise you will clearly understand all the different facets of risk in a very practical manner. More importantly, by purposely trying to lose money as quickly as possible it will become very evident what losing behaviors are. It’s also much harder to do than you would imagine. You’ll be surprised how many of the things you perceived as ‘risky’ might actually make you money.

While you contemplate the “losing $1 million dollars” exercise, simultaneously imagine you’re sitting in the conference room of the most successful hedge fund in the world. The entire hedge fund team is meeting to strategize about new asset selection and review past performance. You’re asked to provide your best stock pick for the hedge fund to add to its portfolio. Honored by the opportunity, you select “stock x” and share it with all the attendees of this meeting.

Assuming that your stock pick is warmly received how much of an allocation do you think they will make to their portfolio?  In my humble opinion, you would be lucky if they allocated even .5 of 1% of their portfolio to your stock pick.

Huh?

What separates great traders from ordinary traders is an appreciation of position sizing relative to the size of their account. Ordinary traders love the thrill of finding a great stock and then going “all in.” An ordinary trader will often commit 100% of their account size in the hopes of growing their account quickly. Or worse yet, will trade on 2 to 1 margin to even gain further leverage.  Usually, these traders are sadly disappointed and their performance is dismal. Because they ignore position-sizing they always search for the holy grail.

Top traders instinctively understand that great trading is never about how much money you make when you are correct.  Instead, great trading is all about how little you lose when you are wrong.  What ordinary traders have yet to learn and appreciate is that managing your bankroll is superior to stock selection.

If the hedge fund allocates your stock pick and it goes up 100% in the next week, they have added ½ of 1% to their bottom-line performance. But let’s say your stock pick is a total loser and it goes down to zero in the next week. They have lost ½ of 1% from their performance. In other words, in either case, they survive to trade another day. This point is crucial to comprehend.  Once this skill of learning to trade small is mastered a trader learns to increase the position sizing of their trades. This is central to how professionals position themselves in the markets. The way little accounts get big is by position sizing their trades so that risk is successfully managed on every position. Should one or two trades crash and burn it does not affect the viability of your overall account.  As an airline pilot friend of mine likes to say, “one mid-air collision can ruin your whole day.”

What we are really talking about is cold hard probabilities. You can prove this to yourself with a simple coin toss.

Let’s imagine I’m going to give you 2 to 1 odds and ask you to toss the coin up in the air. We’ll start with a $100 bankroll.

Theoretically, you’ll toss it 100 times.

If the coin comes up heads, you get paid $2 for every $1 you bet.

If the coin comes up tails, you’ll lose $1 for every $1 you bet.

In the real world, only an idiot would give you these kinds of odds as tossing a coin is an even money activity since the outcomes are evenly balanced.

This example is a recipe to print money on demand. ?

How much are you going to bet on each toss?

While you decide on how you are going to answer that question let’s look at the known variables and expectations of the problem illustrated.

We know that there is a 50% chance you will be correct on the outcome you choose.

We know that there is a 50% chance you will be wrong on the outcome you choose.

However, every time you win you will win twice as much as you lose.

How much are you going to bet?

Let’s say:

1. a) You can bet 10% of your total account on each flip of the coin.
2. b) You can bet 25% of your total account on each flip of the coin.
3. c) You can bet 40% of your total account on each flip of the coin.
4. d) You can bet 51% of the total account on each flip of the coin.

If you get this concept correct everything else is footnotes. However, if you get this concept wrong, you can do everything else correctly and you will be a loser. That is pretty much guaranteed.

Most traders think that predicting the outcome of each and every trade is important.

They spend all of their time and energy focusing on what SHOULD occur next.

So, how are you going to bet?

The results are as follows:

If you chose a) 10% after 100 flips your account would have grown to $4700.

If you chose b) 25% after 100 flips your account would have grown to $36,100.

If you chose c) 40% after 100 flips your account would have grown to $4700.

If you chose d) 51% after 100 flips your account would have fallen to only $31.

These results are completely counterintuitive.

As you might have guessed most traders fall into category D.

Inexperienced traders are obsessed with the potential rewards and they often overlook basic money management. They find exciting opportunities and then over commit to them convinced that they will make huge returns.

After all, you have 2 to 1 in your favor on a simple coin toss.

How in the world could you lose?

Success in trading is never about how much money you make when you are right. It is ALWAYS about how little you lose when you are wrong.

Now let’s get back to the exercise where I am asking you to lose $1 million as quickly as possible.

There really are only a handful of ways for you to lose $1 million dollars as quickly as possible.

• Trading is exciting. But even in a commission free world there is a spread between the bid and the offer on every transaction you make. Assume the spread between the bid and the offer is 1/8^th of a point. You trade eight times and theoretically you have given up one full point. Trade for profit not for the adrenalin rush.
• Taking on too much margin debt in pursuit of gains.
• Ignore Trends. Want to lose money quickly? Get long in a firm downtrend or get short in a firm uptrend. If you were really looking to lose $1 million as quickly as possible what you would need to do is commit the entirety of your account towards a trending market and trade against the trend. Try this sometime in your demo account and you’ll quickly appreciate how important trend analysis is towards wealth accumulation.
• Bad Money Management. Money management is always about protecting your bankroll above everything else. The market is going to be here tomorrow, are you? Learn to trade small so you can live to trade another day.

These four things are at the heart of understanding RISK in your trading activities.

What Is It That You Really Want from The Markets?

Most traders DO NOT WANT TO WIN.

They will tell you differently and they can be super convincing, but their behavior will tell you otherwise, but you can always tell the truth by following the money and studying the results.

You need to know this truth before you step into these waters.

How good are you at making decisions?

What has your performance been this year?

What’s Your Best Chance to Make Money In The Financial Markets Today?

The Answer A.I. Offers Will Surprise You.  Intrigued?

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Discover why artificial intelligence is the solution professional traders go-to for less risk, more rewards, and guaranteed peace of mind.

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IMPORTANT NOTICE!

THERE IS SUBSTANTIAL RISK OF LOSS ASSOCIATED WITH TRADING. ONLY RISK CAPITAL SHOULD BE USED TO TRADE. TRADING STOCKS, FUTURES, OPTIONS, FOREX, AND ETFs IS NOT SUITABLE FOR EVERYONE.

DISCLAIMER: STOCKS, FUTURES, OPTIONS, ETFs AND CURRENCY TRADING ALL HAVE LARGE POTENTIAL REWARDS, BUT THEY ALSO HAVE LARGE POTENTIAL RISK. YOU MUST BE AWARE OF THE RISKS AND BE WILLING TO ACCEPT THEM IN ORDER TO INVEST IN THESE MARKETS. DON’T TRADE WITH MONEY YOU CAN’T AFFORD TO LOSE. THIS ARTICLE AND WEBSITE IS NEITHER A SOLICITATION NOR AN OFFER TO BUY/SELL FUTURES, OPTIONS, STOCKS, OR CURRENCIES. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE DISCUSSED ON THIS ARTICLE OR WEBSITE. THE PAST PERFORMANCE OF ANY TRADING SYSTEM OR METHODOLOGY IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.