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When you pay attention to the financial markets and all activity surrounding them, you start to see one simple pattern that pretty much guides everything.

1. Things go up — everyone’s happy.
2. Things go down — everyone starts blaming the government.

It would actually be kind of humorous if it weren’t so frustrating. It’s as if the world believes that the purpose of the market is to earn them a return of 10% per year or more, no questions asked. With so many people in our country and around the world tying up their life savings and retirement savings in index-tracking funds and equities, it’s no wonder this is the case. Somewhere along the line everyone started believing that the market would earn them better returns than their bank accounts and … well … they forgot about the risk.

That’s right. In case you didn’t know, there is risk involved in investing in equities or any other financial instrument. That risk exists whether you’re in mutual funds in your 401k or straight-out stocks in your non-retirement funds. Put your money into the market and ten years from now you might have less money than you have now.

Seriously, did anyone notice what just happened to GM. It just hit 50 years lows. Meaning that if you had put your money into old, faithful, GM fifty years ago and held on, today you’d have just about the same amount of money as you did then. No gains, not even inflationary gains.

So I guess it’s no wonder we all just scream for the government to fix things. I mean, it is our nature to blame others. It’s not unexpected, I just wish it weren’t so. Either accept the risks involved in your own financial strategy, or put your money in a bank or money market where you will get a guaranteed, albeit smaller, return.

Let’s say that gas is around $3.75 per gallon. Do you think it’s going higher? No, I mean really. Do you really think it’s going higher in, say, the next three months?

If you do, then you could go on down to your local gas station, meet with the owners and make a proposition. You could tell them this:

“I’d like to enter a contract with you. I want to be able to buy 100 gallons of gas at the current price of $3.75 per gallon at any time between now and the end of August 2008. Can we make a deal?”

Naturally, the gas station owner is going to put a price tag on this deal. After all, why would he lock in this price for you when gas could go higher? On the other hand, for the right price, he might be willing to make this deal. Why? Because it’s also possible that gas doesn’t go higher and selling this contract could bring in some extra cash for him. Let’s say he agrees to sell you this contract for thirty cents per gallon, or $30. You accept and the deal is done.

This contract you have created is a call option on gasoline. It is just like the call options you can easily buy and sell on many stocks, indexes, futures and other products. It has a strike price ($3.75/gallon), an expiration date (August 31, 2008) and a price ($0.30/gallon). It also contains 100 gallons per contract, just as equity / index options usually trade at 100 shares / contract.

In my previous post, I made the case that everyone is a gambler. I also posed the following question: “what’s the difference between gambling at the casinos and gambling in the stock market or with mutual funds?” I got some thoughtful replies and, after considering it further, decided I would continue the discussion with another post.

To me, casino gambling, stock market investing, starting a business … etc., it’s all a gamble. It’s all the same. There’s no intrinsic difference in the activities themselves. They are all games and they follow the same rules of risk, reward and probability of success.

The difference can only be found in how one approaches and plays the games. It is possible for someone to approach the stock market as a gambler, just as it is possible for a person to treat casino gambling like a business. In my opinion, the difference comes down to one thing: risk management.

Whether you invest your money in stocks or in casino gaming, you are only treating it as an investment if you practice a solid plan of risk management. Without this component, you are simply throwing money toward chance, and it is this practice of betting on chance that gives casino gambling its wasteful reputation. I would argue, however, that it is just as common for people to play in the stock market in a wasteful manner when they don’t practice risk management.

Risk management is a practice of understanding all of the factors that can influence the possible outcomes of your play, and building a solid plan around these principles. Risk management makes it imperative to have a plan in place for your trading or gaming. Without a defined plan, one is not managing risk because without a plan, one will generally just bow to emotion and give in to the feelings of the moment, which almost surely results in loss.

A person who makes a solid profession out of playing poker understands risk management. They have a plan and they practice that plan every time they play. They know how much they are willing to lose on each hand, each game, each month, each year … etc. They know the probabilities for every hand they are dealt and they know how they will react to every possibility they encounter. The professional poker player treats poker like a business. They preserve capital and operate with a plan. To me, this person is investing because they are putting money into a system, or business model, that they believe will be profitable over time. The casino gambler who doesn’t practice risk management, on the other hand, just throws money at chance without a plan in place. This practice relies purely on luck and, over time, this gambler will generally lose.

I think most would agree with the above point, but here’s where I think this intersects with a majority of Americans in ways that most don’t understand. The stock market is also a gamble and unless you practice risk management, you are not really investing, but rather just taking a chance. The “safety net” that has kept most people out of trouble while they have thrown their life savings into mutual funds and stocks is that, over time, the equity markets have appreciated. So, even though people don’t understand what they are really putting at risk, they have come out OK because the markets have saved them by being resilient.

Problem is, the more the market proves itself this way, the more people tend to forget about the risk. It is this psychological phenomenon that led to the housing and credit crisis we are now enduring. People got overconfident about the resilience of housing, thinking it could never go down, and they placed large bets on the belief that housing would always go up. I believe the stock market also holds this illusion of infallibility in the minds of most people. We come to believe that the stock market is a “sure thing” as long as you hold on for the long term. But it’s not a sure thing. The markets do tend to go up over time (at least in recent history), but what if you put your money in at the wrong time? Or, even worse, what if the markets stop going up, or start going down?

We recently got to witness the results of this problem. As the Dow fell from 14,000 to 12,000 recently, the nation started screaming for justice. Everyone looked to blame the politicians or the oil companies or whoever else they could find to blame. Nevermind the fact that the Dow was still holding 12,000, which up until a couple of years ago had never even been hit. Here we are exponentially higher than we have been in recent history and yet our nation was demanding that our leaders do something to stop the decline.

Why does this happen? Because most people have most of their money tied up in the markets or instruments that respond to the markets yet they don’t understand or manage their risk. They simply expect their money to grow year after year and to grow by a hefty percentage at that. This is what years of growth have taught us to rely on. It’s what most people believe to be true. But it’s unfortunate because the truth is that the stock markets, just like the casinos, are a gamble, and to be successful you have to either be lucky, or practice a solid plan of risk management. Most of us have been lucky for the past many decades. But what if that were to change?

I’m a pretty serious student of the financial markets these days. The other morning on CNBC, they were doing a little shtick where they were simulating a poker game with some big name hedge fund managers. All the while they were (sort of) playing, they were discussing the similarities between poker and trading. These hedge fund managers had also done well in some professional poker tournaments.

This little vignette solidified something I’d been thinking about for a while. That is, everyone is a gambler.

When you study the markets and people who make a business of trading in the markets, you slowly become aware that everything is simply a game of probabilities, risk and reward (for more of my thoughts on this, you can check out a post a wrote a while back specifically on this subject). These very same principles that allow an individual (or a professional) to make money in the markets also guide the games of chance at the casinos. They also guide pretty much every other decision we make every day of our lives.

When asked about the similarities of trading and playing poker, one of the hedge fund guys explained that in both cases, you are presented with a certain amount of information, but there is always a piece of information that you don’t have. You have to make a decision on how to handle that missing piece of information based on your understanding of the information you do have. You make a decision, place your bets, and hope for the best.

Honestly, can you say that this is different than anything else in life? There is no certainty about tomorrow. We are always dealing with an incomplete information set and making decisions the best we can based on what we know. When it gets right down to it, we always have to move forward, choose our path, and hope for the best.

This is why I say everyone is a gambler. So, why do we consider gambling to be “bad”? What makes tying up hundreds of thousands of retirement dollars in equity-based mutual funds (which can lose their value) any more virtuous than hitting the casinos? Or, what about the person who invests a large portion of their net worth into a new business venture — are they somehow more noble than the blackjack player? I have some thoughts, but I’d like to hear yours first in the comments. What do you think?

This was a hard week in the market. The lovely upward trend broke down. Doesn’t mean it’s over for good, but at least for now, things are a little uncertain and directional trading just got a little bit harder.

I definitely fared better on this correction than I did back on 2/27/2007. That gives me hope that at least I’m making some progress and learning.

Today was my best day of trading in my four month trading career. It was a welcome change from the four previous days, which were really trying my patience and emotional fortitude.

Today I closed out a trade for a 1000% gain. Those of you who have traded options know that is not really as big a deal as it sounds, but it’s still fun to say. There’s a lot more to it than just a big return on a single trade and this by no means makes me a great or accomplished trader, but I did learn an important lesson.

I learned that it is possible to hit the homerun, and when you do, it plays a very important role in the trading process. It compensates for a lot of small losses and gives you momentum.

This big trade adds to the additional satisfaction I felt today when my patience was rewarded and many of the trades which had been lagging made some moves in the right direction. Earlier in my long career, I would have exited most of those trades before they had a chance to prove themselves. Patience was rewarded today.

Alas, I am celebrating today’s successes for now, but will soon return to preparations for tomorrow. After all, each day is an unknown.

Oh, and one more thing. My 1000% gain was from an option on Chipotle. Even sweeter when my favorite limited service restaurant goes the extra mile to deliver a winning trade!

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.

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.”

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.