Relationships on Wall Street come in many stripes. Some are as fickle as the weather – strong one day and weak the next. Others are firm and reliable, like your wife’s love. But a select few sit in a class of their own. Their bonds are eternal, everlasting. They’ve existed since the dawn of markets and will be here until Armageddon and beyond.
Today I want to highlight one such relationship that is manifest in every single trade you take. It’s not a link between two actors, but three. You know them well. There names are
‘Tis a trio of utmost importance.
Risk vs. Reward
I cut my teeth trading stocks. In that realm, everything hinged around risk and reward. My entire life, it seems, was spent scouring for that magical pattern offering little risk in exchange for a large reward. Sometimes the landscape was a wasteland, devoid of sustenance. My account grew thin, my belly thinner. Other times, the market became a veritable garden of Eden, teeming with opportunity.
I was correctly taught to favor chart setups that provided at least $2 of reward for every $1 of risk. The more asymmetric the risk/reward, the lower my win rate needed to be. For example, if my average gain is $3 and my average loss is $1, then I only need a win rate of 35% to come out profitable in the long run.
The baseline odds for a stock trader is 50/50. You can buy any stock at any time and have a 50% chance of success. This underscores the need for a low risk/high reward payout.
Embedded in that explanation is a nod toward probability. It matters a great deal.
Enter, Probability
You cannot properly assess risk and reward unless you know the probability of actually capturing the reward. Risking $1 to make $9 can be a bad idea. And risking $9 to make $1 can be a good idea.
It all comes down to the odds.
Risking $1 to make $9 is a money loser if your win rate is only 8%. Risking $9 to make $1 is a profitable venture if your win rate is 95%. In an efficient market, everything is adjusted for probabilities. You will never discover a low risk-high reward strategy with a super high probability of profit. Nor will you find a high risk-low reward strategy with a low probability of profit.
The Other Guy
The easiest explanation for why the link between these three amigos is everlasting is to remember that there is always someone else on the other side of your trade. And he is a rational actor, not some drunk bozo doling out free money. When you deploy a low risk, high reward trade, someone else is taking a high risk, low reward trade. If in this exchange you had a high probability of capturing your high reward, then he has a high probability of incurring a large loss. Why would anyone do that?
They wouldn’t.
That’s why high probability, high reward trades don’t exist. Nor do low probability, low reward trades.
That’s the first point. The second point is that there are traders that make money with both methods. Or, I could say it the other way. Some traders lose money with both methods. Some people focus on directional trading with an emphasis on playing low risk-high reward chart setups. Others embrace the high probability world of options selling, settling for high odds and low returns per trade.
Success is not a function of which method you pick. It’s a byproduct of skill, discipline, risk protocols, and trade management.
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