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Last week I wrote about the insurance business as a model for trading. There are two key components to the success of that business – the law of large numbers and the quality of your underwriting. In traders terms that means that you should make a lot of bets that a have a probabilistic edge and you should avoid any trades that so much as hint at more risk than you are willing to assume.
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Insurance companies essentially charge very little money for potentially large payouts. It is the classic negative risk reward ratio trade. They try to minimize their risk by refusing to insure anyone who may actually need their service (that’s why health insurance has to be a public good – but that’s a discussion for another day). For example, insurance companies are loathe to insure drivers that have been in several accidents, that have collected many tickets for speeding or that have been cited for moving violations. In a game of negative risk reward bets it is ALWAYS better to pass up on a risk that falls outside of your underwriting parameters. Thats why many daytraders will simply get flat ahead of any major news release rather than risk being stopped out for a massive loss.
There is however another model for trading – one that is much more commonly espoused – which seeks to make bets on the more common positive risk to reward ratio. When using that model we should look to the venture capital sector for guidance on how it should be done. Venture capital, contrary to the propaganda from Silicon Valley is not the art of “carefully researching investment opportunities in order to seed the most promising technologies and businesses”. It is in fact the art of making a lot of bets in order to cash out on 1 out of 100 of those investments.
The truth of the matter is that no one knows what a “promising technology or business” is. For every Facebook there are a hundred Friendsters, Paths, MySpaces and Google+ floating around like carcasses on a river. Therefore, venture capitalists try to “cover the table” with a lot of small bets and hope that one of them pays off.
For us as traders the key to understanding that model is to realise two things – you must keep your initial bet size very small and you will lose. A LOT. Imagine making nine trades in a row, all of which are stopped out. That is just a regular day of work for a VC (the more accurate ratio is more like 95 stops out of a 100).
If you are a VC whose investments take years to work out, the prospect of so many losses is ameliorated by the passing of time. But if you are daytrader, the psychological toll of so many stopouts in a row can be heavy. Furthermore, the risk of missing that one golden opportunity can completely ruin your model for success.
This week’s seminal USD/JPY trade is a perfect example. The pair has been threatening to take out the 100.00 level for weeks, but each break out failed. There was nothing particularly special about yesterday.If you polled 100 traders in the morning asking them if USD/JPY would catapult through 100 on that day – 99 would have probably said no. So if after four or five stop outs you didn’t make another “investment” in USD/JPY yesterday you would have missed the one opportunity for a payoff.
The venture capital way of trading is a very valid model of doing business, but you must understand its rules before you attempt to trade like the Silicon Valley master of the universe. Unlike the insurance model which eschews risk at any opportunity, the VC model seeks it out anywhere it can. In short if you are going to trade with positive risk reward ratio you need to remember that you “gotta be in it to win it.”