Always Plan your Trades

Imagine that a friend offers you a wager. If you can pick the correct outcome of a coin flip, they will pay you 50 rupees. If you guess incorrectly, you pay 100 rupees. Would you play this game? Of course not. Assuming that there is a 50-50 chance of you guessing correctly, the amount you could possibly lose is double that of what you could possibly win.

After you say no to your friend, they instead propose to pay you 55 rupees if you guess correctly but you will only pay 50 rupees if you are incorrect. You would likely play because the payout is in your favor despite the odds of guessing correctly is the same as guessing incorrectly.

Even though this game is weighted beneficially to you, you still may not want to do this because there is a very real chance of this game costing you 50 rupees. Instead of playing this game one time, what if your friend has deep pockets and is willing to play for dozens or hundreds of rounds. If you play once, there is a chance that you can lose. It may even be the case that you pick heads 5 or even 10 times in a row but the coin unfortunately comes up tails each time. Over many, many coin flips though, the number of times that heads appears should equal the number of times tails appears – assuming that the coin is “fair”. If your friend is willing to play long enough such that the coin’s outcome of heads vs. tails is 50-50, then you will end up ahead because you are paid more for a win that you pay out for a loss.

You play several hundred rounds of coin flipping with your friend and as expected, heads came up 202 times and tails came up 198 times; roughly 50-50. In the end, you were profitable just as you anticipated. Your friend now wants to shake things up. He proposes a game where you guess the outcome of rolling a pair of dice. Each die has 1 to 6 on it so a pair will have total values ranging from 2 to 12. Of course, some numerical outcomes are more likely to occur than others. For instance, 2 can only be happen if two 1’s are rolled. On the other hand, 7 can be a combination of rolls that are: 1 – 6, 2 – 5, and 3 – 4. With this game, you will win only if you roll a total that is less than 4. This is different than a coin flip where there are only two outcomes and those outcomes are weighted the same. To determine whether or not you will play this game, you will need to understand the likelihood of winning, how much you will get paid if you win, and how much you will have to pay if you lose.

While trading and investing isn’t a game, you still need to understand the rules of the trade you are entering. Planning your trades is critical to risk management. Understanding how much can you gain, lose, and the likelihood of winning are a few of these metrics that are needed to assist you in planning your trades. In the next several lessons, we will discuss this and others that you should know before clicking “Buy” or “Sell”.