DailyGenesis.com

Trading options has introduced me to the relationship between probabilities, reward and risk. But the more I think about it, the more I realize this is not just a trading concept or even just a financial concept, this is a guiding principle of life. Let’s take a look.

Reward / Risk is inversely proportional to probability.

What does that mean? Well, let’s look at a few examples to illustrate.

The lottery. When you buy a lottery ticket, the potential reward is extremely high, possibly millions of dollars. The risk is extremely low, only a few bucks for a ticket. High reward divided by low risk equals a very high ratio. Since the reward to risk ratio is inversely proportional to probability, we can assume that the probability of winning the reward is extremely low. Are we correct? Absolutely. The probability of winning the lottery is extremely small.

Trading options. If you wanted to, you could approach trading options just like playing the lottery. Buy a bunch of $0.05 options. Set your target price at $1, you just made 20 times your money. Want more, set your target at $2 for a 4000% gain. The higher you set your price target, the higher your reward to risk ratio goes. But at the same time, the higher your set your price target, the less likely you are to achieve that target. So, if risk stays the same, then as reward goes up, probability goes down.

Beyond trading and finance.

Now let’s think about the bigger picture. Isn’t all of life just a continual series of reward to risk scenarios? For example, a baby starts to learn to walk. He has in his little mind a reward (to walk). The reward in this case is a constant, and so the variables here are risk and probability. When the baby starts trying to walk, he will risk falling down. What if the baby wants to try and avoid this risk. Well, if he never tries to stand up then he never takes on the risk. But at the same time, what happens to his probability of success if he never tries to stand? That’s right. As risk goes down, probability of success also goes down.

Now the baby is a young child who wants to learn to ride a bike. Learning to ride means taking off the training wheels, but there is a risk involved in that. If the training wheels never come off, the risk is reduced dramatically and so is the probability of achieving the goal (reward).

Into the emotional.

Now the young boy is much older. He meets a girl. He likes the girl. He wants to develop a relationship with that girl, possibly even a life-long marriage relationship. But there’s a risk involved. It’s an emotional risk. That is, if he commits himself emotionally to the relationship, there is a risk that he will get hurt.

So, he decides to limit that risk. He decides to hold back his emotional commitment — to avoid engaging fully in the relationship. As he does this, his risk goes down but what happens to the probability of success? Most likely, if he’s not willing to commit emotionally to the relationship, it is more likely to fail.

But what happens if he changes the reward? Maybe instead of a marriage relationship, he changes the goal to simply having a casual friendship. The reward goes down and therefore the probability of success goes up. He can limit his emotional risk and still potentially have a friendship. Higher reward requires higher risk if you want to keep the probabilities the same.

The probability factor.

When I was growing up, I often heard that if you wanted to do something great, it required risk. In other words, I understood reward and risk to some degree. But the part I never heard about was probability and how it was related to reward and risk. To me this makes a big difference. I know this has been a pretty philosophical discussion, but there are a few practical conclusions we can draw from it.

1. The reason get-rich-quick schemes don’t work is because they violate this concept. They try to tell you that you can achieve a great reward with very little risk. But we know that if reward is high and risk is low, the probability of success is low as well.
2. We should learn to accept a reasonable amount of risk and also to aim for a realistic reward. Trying to eliminate risk or aiming for an extravagant reward will ensure failure time after time because of low probabilities.
3. Have respect for the equation and realize that over time, coming out ahead, even by a little bit, is a great success.

I’m a big fan of wordpress and I love the fact that there are so many freely available themes to choose from. But, recently I’ve actually tried for the first time to find a theme that could work for my blog until I have the chance to create a custom theme.

That’s when I discovered that while the plethora of wordpress themes are a good thing in theory, it can be a real challenge to find one that actually works well. Since I didn’t want to sift through the thousands of themes out there on my own, I started with this article on 83 beatiful wordpress themes from Smashing Magazine. But, as I sorted through the list, I grew more and more disappointed. I found a handful that I sort of liked, but then when I actually tried them out, I haven’t yet found one that I feel is just right.

I am pretty picky, I’ll admit, but why can’t all of these great wordpress themes “work”. So many of them have missing pieces like separate templates for “pages” instead of posts or improper handling of comments, or not including a spot for links. To really fine tune things, I think I’m just going to have to build one myself.

So, I’m back to the old default theme for now. It may be plain and overused, but it is full featured and works great on all counts. Hopefully a new custom theme will be coming soon.

UPDATE 4/30/2007 — Through a little HTML and CSS tweakage, I’ve now created my own custom Wordpress theme out of the Wordpress default theme. This will continue to evolve but for now, I feel better at least knowing it’s a little bit unique.

Please note that this article has been republished on EatAroundOKC.com. Please follow the link below to see the article:

“BrewHaHa is a bit boring“

Emotions are the most powerful force in the universe. At least that’s what I think today. I might feel differently tomorrow.

There are a lot of ways in which emotions exert their power, but one way I have noticed recently is in trading.

Sometimes I paper trade a trading strategy. I don’t really do it on paper, but use a software that let’s me practice trading with fake money. I’ll have huge success. Then, I’ll trade the exact same strategy with real money, and I lose.

What’s the difference? It’s emotion. I would not have even thought about this before, but I’m now convinced the single hardest thing about trading is learning to deal with emotion. Emotion leads you to bad decisions. When it’s fake money, it’s easy to say “let’s just give it a little more time and see if it turns around.” When it’s real money, that doesn’t work.

So how does one overcome emotion in trading? I’m still working on that, but I know at least three things:

1. It takes practice, just like anything else. I had to admit to myself that I had to practice dealing with my emotions.
2. The less money you have at risk, the less emotional you will be. So, starting extremely small and gradually notching it up is the best approach. The gradually part is critical to that last statement. Human nature will say “as soon as I see success, jump in with both feet.” That will be your doom.
3. You have to develop a trading system and make decisions based on the system, not based on a whim. To do this, you have to work a system over a period of time so that you can trust the the system. Given this, it’s not something you can do quickly. It takes time. Your first goal can’t be to make money. Your first goal has to be to “learn to trade.”

This weekend, I finally completed my 2006 tax returns.  Once again, I used TurboTax online, though I am starting to get little disappointed in them for continually raising their prices.  Of course, being back in Oklahoma means State Tax as well and not only do you have to pay state tax, you have to pay more to file the state tax.  Oh, well.

2006 was an interesting tax year for me with self-employment and a couple of salaried jobs all rolled up into one.  Luckily, I set aside monies throughout the year to cover what I knew would be a tax liability.  After paying the federal taxes I owed, state taxes I owed, plus making an estimated payment for 2007, I ended up almost to the penny on what I had set aside (big sigh of relief).

2007 should also be an interesting year, especially if my goal of learning how to trade works out and I start making trades in a taxable account.  Reporting all of that should be loads of fun for early 2008!

I know we’re already 1/4 of the way into the year, but I’m just starting to post on this blog which I’ve had running for a long time. So, I thought I’d start with my 2007 goals.

This year, I did something I’ve not done before, I set out a clear goal for 2007 for myself. My goal is — master stock market trading and investing.

I’m pursuing this goal in earnest and what a ride it has been so far this year. I am actively trading in the markets now, though it is currently with very, very small amounts of money as I am still just learning.

My advice to anyone else who wants to start out and tackle this goal is this. First, realize that it’s not easy, but it can be learned. Second, start out with very, very small amounts of money. Third, make it your goal to to LEARN how to trade, not to make a lot of money.

When I first got started, I was really anxious and impatient because I felt like I had wasted so many years of my life not investing and I wanted to catch up and get started. That was an unwise emotion to start out with. It’s not a quick game. It takes a lot of practice.

If your goal is to make a lot of money, and especially if you have an impatient time horizon, you will risk more money to do so. If your goal is to learn to trade, you can risk very little and make very little, but at least you learned. Then, some day down the road, I will start stepping up the amounts little by little.

At least that’s my approach for now. We’ll see how the year progresses. One thing I can say for sure is this — I know about 100,000 times more now about trading than I did in December. So, in that sense, things are going well.