Forex Trading Tips: The Risks You Know

The Risks You Know

The longer I trade the more I come to the conclusion that you have to trade like a casino or an insurance company. No, I don’t mean that you should start thinking about setting up your own blackjack table or begin offering life insurance products, but rather that you should only trade the risks that you know and generally stand aside the rest of the time.

The house edge in blackjack using liberal Las Vegas rules is only a miniscule 28 basis points. In baccarat it is 1.06% if you are the banker. In video poker it is just 46 basis points. The numbers are ridiculously small, yet they are enough to allow Steve Winn to buy Picasso’s, Warhol’s and Van Gogh’s and graciously display them in his art museum ( a true hidden jewel in Vegas visited only by me and retired old ladies from Midwest).

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The story is the same with life insurance. If you are in you mid-thirties to mid-forties, don’t smoke, are not overweight and have no chronic medical conditions it takes only about $1000 per year to obtain a $1M term life insurance policy. That seems incredibly cheap and you may wonder how insurance companies are able to offer such low cost protection. Do they just run a massive Bernie Madoff ponzi scheme and refuse pay off when you die? Well this being insurance some do, but generally they don’t have to. The odds of them paying out a claim on the type of cohort I described is just 1 in 60,000 which means they can expect to bank $59M each year from every 60,000 policies they sell. Not a bad gig.

Of course both insurance and casinos are basically fixed odds systems. Under the law of large numbers the payoffs are practically guaranteed. Trading is not nearly as neatly forecastable by statistics. Unlike casino games the outcomes in markets are much more difficult to predict. Investment returns suffer from what is known as fat tails – events that under normal conditions would happen only once in every 10,000 years, occur in markets once every decade. That’s why in trading it becomes even more important to follow the casino and life insurance model and assume only the risks you can forecast.

Suppose you’ve been playing backjack for a while in Vegas and you are up 1M on the house. What happens? Do the pit bosses glower at you? Do dealers looks at you in fear and disgust? Quite the opposite. The waitresses offer you free drinks and ask if you would like a Kobe burger brought to the table all courtesy of the house. The pit boss approaches you and congratulates you on your recent winnings and suggests that as a gesture of goodwill the casino would be glad to put you up at their $10,000 night penthouse suite for as long as you like and will be happy to attend to your every need. What the hell is going on here? Why is the casino being so nice? Because they know that the longer you stay at the table, the greater the chances that you will give all your winnings back.

Now imagine you belly up to the blackjack table and place 100M worth of chips on a single bet. Do you think any casino would take your business? Of course not. Although casinos know that over the long run the edge is theirs, on any given hand the odds could easily favor the player and the prospect of 100M loss is much too great a risk to the safety of their business, Casinos trade only the risks that they know and stand down against everything else.

If only we as traders could follow such steely discipline! The irony of trading isn’t that most setups don’t work – many in fact work very well. In trading there is a thousand ways to make money. Unfortunately, there is only way to lose it – by taking unnecessary risks. Next week I will discuss some of those risks as well as some practical ways to avoid them.

For anyone in the Middle East, I will be giving presentations in Oman on May 20th and in Dubai on May 25th. Kathy will be covering the desk while I am gone. Hope to see you there.

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