For readers who haven’t been following this series of posts, it makes sense to read these posts first
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The concept of risk-reward is alien to most investors. Before I get to the actionable insights, a brief introduction to what is meant by the trade-off between risk and reward wouldn't hurt.
Many parts of this post apply to the world of both, investing and trading. Let me start with Charlie Munger:
“The point of this exercise is to illustrate that even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds. A horseplayer cannot remind himself of this simple truth too often. Some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.”
“So you have to learn in a very usable way this very elementary math and use it routinely in life – just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer. If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.”
1. A common mistake that we make when we invest is that we have already identified a winner, and we proceed to place a bet, without any regard for the odds. We may not lose capital on such bets, and at times we may even end up making money on these kinds of bets, but we’ve got it backwards. The reason this is wrong is that we aren’t looking for mispricing between the fundamentals and the expectations - which is favourable odds. It makes far more sense to look for better odds than to try and predict winners. The horse most likely to win the race is unlikely to be the best in terms of betting value, is it?
2. What we end up doing is the opposite. We find stocks that we ‘like’ and hope for the best on price. Most honest players will admit that this is indeed the path that they follow. This is the way we all have been conditioned to think: find the winner, then bet, stare at the past performances long enough and the winner will jump off the page. The problem is that we’re asking the wrong question. The issue is not which stock in the race is the most likely winner, but which stocks are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few do. Under this mindset, everything but the odds fades from view.
3. Intuitively we seldom think in terms of risk-reward or odds when we bet. We are guided by our expectations and that may not be the correct way to think in the trading (or even investing) context. Instead, we must think in terms of the risk involved, and then compare it with the obvious trade-off which is the associated reward if things work out. There is an element of luck involved, and that is undeniable.
4. When a given risk is small (either in terms of size or in terms of odds), and a potential reward large, you might as well take the risk and position yourself to become a winner. The point is: the magnitude of success matters more than the frequency of correctness. In other words, one should always take such bets, since it is impossible to predict which one will be the winner. This is what venture capital investing is all about.
5. There is no such thing as ‘liking’ a stock, only an attractive discrepancy between the fundamentals and expectations. And, we want to place a bet when there is an asymmetric Risk-Reward. Hence, we must be on the lookout for convex trades. (That which benefits from randomness - increased potential for upside in the presence of fluctuations, is convex; that which is harmed by randomness, concave).
Now, let’s get straight to the actionable insights:
1. Before we place a trade, we must assess the Odds. The odds on a particular trade depend on the price paid. A bet that has favourable odds would offer more upside than downside. Ideally, the more the volatility, the easier it becomes to identify this kind of set-up.
2. Optionality is the property of a trade that offers more potential upside than potential downside. If one correctly and consistently identify trades that have ‘positive optionality,’ you don’t have to be right that often. As long as you can garner the wisdom to not do unintelligent things to hurt yourself. Or as Munger would say in a different context: ‘The best way to be smart is to not be stupid’
3. The problem is that one has to learn how to look for optionality, one has to judge whether the optionality is priced. Again, not all bets have optionality and then there are so many other factors like the trend, news flow, market structure etc.
4. Most important of all, the odds shift inversely to the duration of the trend. Remember that the return risk ratio is dynamic and can change dramatically once the trade gets older. As an example, consider that you implement a trade, looking for a 300-point gain and risking a 100-point loss. If the market then moves 200 points in favour of the trade, the risk-reward is now drastically different than when the position was implemented. Holding the entire position until it is exited is an attempt to be 100% right, at the risk of being 100% wrong. Such a strategy will result in a popcorn trade. Taking partial profits as a trade moves in your favour not only responds to the fact that the reward/risk of the trade is changing, but it is also another risk management tool. If the market abruptly reverses against your position, the action of having taken partial profits will mitigate the profit surrender or reduce the loss. How does one manage the dynamic nature of reward risk in a trade? The idea is to take partial profits or by placing a trailing stop loss.
From the earlier post on Risk Management: 13. A popcorn trade is one in which you had a profit and you rode it back to where you got it in. Just like a kernel of corn pops, goes up to the top of the canister, and then falls back down to the bottom. Popcorn trades are pretty common and that is because the second leg of the transaction (depending on whether we buy first or sell first) is the critical leg. When we are investing, the BUY trade precedes the SELL trade, and that means the SELL trade is far more difficult than the BUY trade. Similarly, while trading, the second leg of the trade, in most cases this is when we are booking profits (since losses have already been booked), is the more difficult leg of the transaction. Too many Popcorn trades are akin to a game of snakes and ladders, wherein one gets eaten by the snake when the goal post is visible.
6. There is a thin line that separates gambling and speculation. Gambling involves taking a risk when the odds are against you. Speculation implies taking risks when the odds are in your favour. Successful trading or poker playing involves speculation rather than gambling. Just like poker, where you have to know which hands to bet on, when trading, you have to know when the odds are in your favour.
7. When a price moves out of a trading range it is called a breakout and in situations where such breakouts occur for reasons that nobody understands, it leads to trade with favourable risk-reward. Breakouts that occur because there is a story or headline news, are less relevant. The Heisenberg Principle provides an analogy for the markets. If something is closely observed, the odds are it is going to be altered in the process. If a stock is in a tight consolidation and it breaks out the day there is some breaking news, the odds of the price move being sustained are much smaller. If everybody believes there is no reason for corn to break out, and it suddenly does, the chances that there is an important underlying cause are much greater. In other words, the lesser the explanation for a price move, the better it looks. Conversely, the more a price pattern is observed by speculators, the more prone you are to have false signals. In summary, any price moves in a stock that is not the subject of speculative activity, (liquid stocks that are not in the F&O segment), the greater the significance of technical breakouts.
8. One should seek clarity over certainty. The markets are not about certainty; they are about probabilities. Waiting for trades that approach the ideal of certainty, or near certainty, will lead to inaction and missing many trades that offer good probabilistic bets. Seek clarity over certainty. Trying to reach for certainty will keep you from acting when the odds are favourable.
9. Everyone understands that the market is a discounting mechanism. What we don’t pay attention to is that the discounting mechanism is not price; it’s participation. It's not always the case that when the price has gone from 50 to 100, that the optionality is priced. Instead, if everyone is long, only then would the risk-reward have shifted.
10. Thinking in Bets: Making Smarter Decisions When You Don't Have All the Facts by Annie Duke is an excellent read, for those who are interested. I have also posted a book review which is a faster way of embracing what she has said. You can read the book review here: Book Review of Thinking In Bets by Annie Duke.
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