Understanding Downside Risks in Investing
I wrote a post named “What is Risk Worth” a few months ago and have thought of a possible better way to explain some reasons to accept downside risk in investing. This idea stemmed from thoughts left over in my head after writing my Four Stages of Succesful Investors series. I’ve had a fairly comfortable relationship with risk since I started investing. None of the monies I deposited to my brokerage account for years were earmarked for use anytime in the next 10 or more years and the occasional down times didn’t bother me because I believe, given long enough, markets recover.
A couple of years ago, work was busier than it is now and I had little time to focus on investing, especially with an infant at home. I read about the predictive market, Intrade. I joined and quickly found a trading model that worked for me. Every night before bed I entered two orders, one to say the Dow Jones Industrial Average (DJIA) would not close above +75 points at 10:00 a.m. and one to say the DJIA would not close below -75 at 10:00 a.m. every day. If both hit I was guaranteed one would win with a small probability the other would not.
In a predictive market a buyer offers a price they are willing to pay in the likelihood an event will occur and the seller offers a price they are willing to sell the likelihood the event will not occur. Prices vary depending on the likelihood or probability of occurring. If the contract was on flipping a coin the bid/ask should always be around 50/50. If the contract was on rolling a six on a single die the bid/ask should be around 16/17, ie a one in six chance. Without going in too much deeper about predictive markets, the short explanation for these contracts was that they were only open for about 12-18 hours and when closed all money was settled within five minutes. Emotions played a huge roll in determining the prices based on what news was announced each morning.
I played the odds and sold contracts for $0.50 every morning. If I sold 100 contracts I’d make $50 and if I was wrong in my prediction I’d lose $950. I was able to make one or two trades per day and be done by 10:00 am with no money left at risk. I took big risks to lose large percentages, but my probability of losing was low. Of course I didn’t start off selling 100 contracts per day. I slowly increased my contract number based on the gains I had so far. Eventually I learned I could trade half as often, but get $1.50 per contract instead of $0.50, thereby giving me a profit of $150 on the good days and a loss of $850 on the down days. When I was really lucky I’d sell both contracts and make $300 while the DJIA didn’t come close to crossing above or below 75 up or down. For every three days like this I could handle one down day and still be up $50. If these odds held and I only traded once per week, I’d have almost 6% in gains per month (50/850). As luck had it, I picked a good time to work my model and was quickly up a few thousand dollars. I started regular withdrawals to make sure I didn’t loose any of my initial investment. Eventually I was only “playing with the house’s money” and started making even bigger trades. I finally quit this experiment after having three down days in 11 trading days. I got out with just over a 100% return in one year. My whole plan was to work the model until it didn’t work. I could have continued to work it, but I decided to stick with my initial plan and take my profits while I still had them. It also coincided with a slow down in my job and my son becoming a toddler, both of which gave me more time to research stocks and sleep more.
(If you are not reading this post on www.mytradersjournal.com you are reading it from a site that has plagiarized it. I am adding this notice somewhere in every article I write due to the growing number of scum out there who steal entire posts and don’t credit the authors.)
What dawned on me near the end of my run was that I could make those $300+- profit trades even more often with options with even less frequent downside risk. The busy days at the office slowed around that time and I moved my focus back to stocks and options with the renewed focus on managing risk based on probabilities while continuing to exploit others’ emotions. I rarely lose more than a few hundred dollars on an options trade which makes the probability risk quite low. I recognize that I will lose a percentage of my trades and manage that risk by not extending myself so far that I would get wiped out if there was a sudden market correction or even a recession. What that percentage of losing trades will be different for every investor. The important point is to recognize it and build your model around it.