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Trading Is About Trade Offs

By Boris SchlossbergMarket OverviewFeb 13, 2022 02:17AM ET
Trading Is About Trade Offs
By Boris Schlossberg   |  Feb 13, 2022 02:17AM ET
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The surest way I know that someone is lying about their trading is when they tell you that they trade with a 1 to 2 risk reward ratio and a 70% win rate. Perhaps if that person is extremely picky and trades only ten times per year they may genuinely achieve that goal, but I can assure with near total certainty that if a trader is day trading, or even swing trading with those stats, they are lying or simply super lucky for a period of time.

The reason becomes obvious once you run the math. A trader who claims such results would be able to turn $10,000 into $250,000 within a year without compounding. And that of course is total bulls-t because the market is the most competitive arena in the world and is not in the business of giving you money.

In fact, like any good poker game, it’s in the business of taking your money and that’s why almost all YouTube trading “gurus” are liars.

The fundamental truth of trading is that there is always a trade off. The smaller you trade the more chances you have to win but your wins are tiny. The larger you trade the greater your chance of profit but your chance of success is miniscule.

Imagine if you are driving at 5 miles per hour, it will take you forever to get to your destination but even if you plow right into a concrete barrier you will most likely survive the crash. Now imagine you put pedal to the metal as you fly through the night at 200 miles per hour, the tiniest crack in the road could send you spinning out of control and into certain death. That’s basically trading.

Of course everyone in the game tries to find some middle ground between driving like your grandmother from Boca and some douche from Jersey but given our natural inclination to overestimate our abilities almost everyone in the market drives too fast. Which is why we have so many trading accidents.

There are basically two models of trading success—the lottery model and the insurance model. Almost everyone is attracted to the lottery model where you bet a small amount in hopes of winning a large amount, but just as in real life the lottery is almost impossible to win, so too in trading the small risk/high reward model is much harder than it looks. The markets are simply not in the business of providing hundred dollar bills for fifty cent buy ins. And almost every legendary story of such success is basically a story of luck.

One of the few benefits of being old is that I’ve actually lived through a lot of history so people really can’t bulls-t me that easily. For example, anyone who tells you they went short the day of the 1987 crash and made money is either lying or lucky because what almost everyone forgets is that the biggest one day percentage loss in the market also saw one of the greatest rallies ever recorded.

If you were short after the first hour of trading you got squeezed mercilessly into the early afternoon and the only way you held on to that position was if you walked away from the screen because the mark to the market position of shorts during the 1987 crash—the worst day in stock market history—was actually horrible by mid afternoon until the final cave and collapse.

Indeed, one of the great big swinging d-ck stories from that era was the famed S&P pit trader Lewis Borsellino making a cool $1.3 million in a matter of a few seconds on the Thursday of that week as George Soros liquidated into the low. The Borsellino trade is hailed as the ultimate example of big risk/ big reward payoffs of the lottery strategy but what almost no one will tell you is that Borsellino eventually ran into massive financial trouble even admitting that he had to sell his family's beloved summer home in order to pay the bills. In the end, lottery players always lose.

In fact, the only lottery style player who has managed to survive and thrive for decades is Soros himself, who is well known for making balls to wall bets but with a very interesting twist on risk. Many people have heard of Soros’s $1 Billion dollar win against the Bank of England as he "broke the pound."

What is generally not discussed is how Soros structured the trade. According to the accounts from his key portfolio managers and traders, the fund had built up about one billion dollars worth of profit from trading that year and Soros was simply willing to bet all of that year’s winnings on that one currency bet.

Playing lottery with profits rather than equity was Soros’s hallmark of success, but even that approach is rife with risk and requires his truly unique analytical skills to succeed in the long run.

The insurance company strategy is far less glamorous. In fact, could you imagine anything less glamorous than trying to make 1 basis point net from a day trade? It’s the ultimate grinder approach to risk.

Yet on balance it is probably a far more successful way to trade than "have a hunch bet a bunch." It certainly makes trading feel more like a business (and not the bulls-t "five minutes per day turnkey business" that YouTube gurus try to sell you) but it is a far more practical model for trying to generate consistent returns.

If you ever want to convince yourself of the durability of the insurance model of trading, take a look at the top three players in the field Allianz (OTC:ALIZY), founded in 1890, Axa (OTC:AXAHY), founded in 1816, Prudential (NYSE:PRU)—founded in 1875.

The insurance model has survived for centuries because it rests on three key principles of operation: it always capitates risk (uses stop losses), it is willing to accept very small profits for large risks (negative risk reward model), it relies on the law of large numbers (huge amount of tiny trades) to tilt the odds in its favor and most importantly of all it has has a massive balance sheet to underwrite risk (a very big bankroll relative to trade size).

Not sexy but it works because in the end trading is always about trade offs.

Trading Is About Trade Offs

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Trading Is About Trade Offs

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