Risk and Reward

Imagine a coin-toss game where the odds are even, that is where there is an equal chance of the coin landing on a head or tail. If the coin lands on a head (H) you win $2, if it lands on a tail (T) you lose $1. If we flip the coin 10 times, you only need to win the game 4 times out of 10 to make money i.e. your 4 wins produce $8 and your six losses leak $6, resulting in a net gain of $2. You lost more games than you won but you still made money. This should be the focus of every trader: on making money not winning or losing. The idea is to risk less than what you potentially stand to gain not the other way round. This is called the risk-reward ratio, the higher it is the better. This might seem obvious to say but let me ask you this: how many people do you know of who out of 7 days a week spend 5 looking forward to only 2? By simply observing the hanging faces on a Monday which evolve to euphoric on a Friday, I don’t need statistics to prove there are multitudes. But, wouldn’t it be better to spend 2 looking forward to 5 or best to look forward to all 7? Well, we say time is money don’t we? If you are asked to choose a person to invest in based on how they spend their week, what type of person would you invest in?

The character of risk and reward manifests itself daily in the markets. Novice traders let their losses run hoping to be eventually proved correct. They also become excited by and are quick to take small profits. It takes just one loss to wipe out all their accumulated profits. Professionals do the opposite – they cut their losses and let their profits run. It’s not how many times you win or lose, rather it’s how much money you lose when you are wrong and how much you make when you are right. Trading is not about trying to be right, it’s about making money! Strip off the ego and emotion of trying to prove yourself because the market will humble you.

Richard Dennis is one extraordinarily successful trader. To illustrate his brilliance, he borrowed US$1,600 and turned it into US$200 million in about 10 years. That should startle you! In an interview with Futures Magazine he said “If you look at all my trades for a year, I suppose that all the profits are in five percent of the trades.”

May all you wish for be the least you receive!

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