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I saw something interesting going around Twitter the other day and I wanted to see how different traders would consider this.
Suppose you're in a trade and a Time Traveler appears in front of you. The Time Traveler has seen the future, and tells you "Your current trade has an 80% chance of quadrupling your net worth and a 20% chance of losing your net worth". He then disappears in a flash of light and you're left staring at your platform with a trade currently sitting at scratch.
What do you do? Do you scratch the trade or do you keep it on, and why?
Close it. If I go to zero, I can't eat. Or buy beer. Or trade.
If he said, "20% chance of losing half your net worth," would I take it? In other words, not really be broke, just knocked back a lot.... Probably I would.
Probably I shouldn't, but probably I would....
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Related question: you get a great idea for a new business. You don't get a messenger from the future, but you know that the odds do not favor new startups. (Most new businesses fail.) Do you borrow money and go for it, or take the safe path and decide to pass on it? If it succeeds, you become a millionaire. If it fails, you have left your job and have a pile of debt.
The same issues of risk/reward/consequences. (Although the odds of failing in a new business are much greater than 20%.) Different people have different tolerances. Also, how old are you, what are your skills/job history, do you have a family, and so on, will affect anyone's tolerances, but not necessarily the same way....
This is more a personality survey than anything else. How risk-taking or risk-averse are you? How confident are you about your ability to bounce back? Etc.
So, I would take the risk of the half loss, not the full one. But I probably would take the new-business risk, because I would feel more in control, even with new-business statistics against me.
I agree 100% with you. What I've really come to embrace is the fact that trading is about being around to see the next trade. This opportunity--while it has a positive expectancy--means that the only certain outcome is that you will lose everything. Something with a positive expectancy is only useful if you can make that same trade 100 times or 1000 times without losing everything. And with the more traders that a trader takes, the better his/her reads get, and (hopefully) their personal expectancy will increase.
I had a similar discussion a little while ago which I think follows the same lines above.
Suppose you are going to lose 8 ticks over a string of trades and that there is no way to avoid these losses.
How would you rather do it? One 8 tick loss? Two 4 tick losses? Or a combination of 12 scratches and -1s which eventually stick you -8?
Commissions obviously apply. What is more worth it for a trader? Would you take few trades and pay as little as possible in transaction fees? Or would you take as many trades as you could, pay commissions on all of them, and still end up in a drawdown?
This question has been posed in various forms. I have posited even in different forms. It is based on the "utility value" of money and the risk one wants to take. The utility value is going to be different for different people. The optimal low risk action is very trivial: before the time traveler leaves, you ask for some form of proof. You provide this proof to multiple backers who insure your bet.
The expectancy doesn't change: what changes is your risk of ruin probability.
The other concept you are trying to grapple with is whether or not it is easier to make money from the markets statistically or opportunistically. Efficient markets suggest that it is easier to profit from the market opportunistically then statistically because the imposition against efficient markets is less. There is a greater risk of going off kilter though trying to take opportunistic bets. So, the best traders probably combine the two concepts. For example, if you identified Bitcoin early in the process (opportunistic) but traded it with a statistical edge. Another example might be identifying a market theme (opportunistic) such as higher volatility but trading it in a statistical way. The difficulty problem of trying to profit from the market only statistically is that markets aren't normal.
So, it just means it is less likely that a trader will be able to find success with an entirely mechanical method because the mathematics do not support it because the statistical properties change. This doesn't mean that system trading doesn't work. It just means that without knowing hidden factors then the probability is lower. But, if you can find persistent edges, those exist too then you can trade a system over a longer period of time, sure.
Trend following strategies just if you apply them statistically to markets don't do very well. On the other hand, if you can identify a theme driving the market, a rational reason a market should rally or decline over time and then apply the trend following strategy your ability to profit is not as much an "imposition" against efficient markets.
The heart of the question is related to the utility value of money. As stated, the correct answer on questions like this is to find a backer which is a type of insurance. As stated, I would seek to find a backer/insurance and keep it. I presented this question as such lose everything or make 500 million with 90% odds: ask 1,000 people at a beach this and 100 will lose everything even though they had a huge edge. You can also change it around like, win 10 billion at 50% probability or lose everything. Given that most people no matter what they do will never make 10 billion even a coin flip is better then any other opportunity. But whether or not any individual should take the bet is based on their utility value of money and personal situation. Obviously, Bill Gates is not interested in that bet whereas someone in late teens or 20's living at home, with maybe $2500 to his name, well that's a no brainer. This is a sort of reverse insurance question.
Now if you are talking or thinking about a statistical probability event, that gets at a different matter. Obviously it is always better to risk less per trade if you can still have an edge but for most futures traders it is simply not possible because they cannot obtain edge in those spaces.
Unfortunately, that isn't one of the choices and is an invalid answer in this situation. You are only allowed to to either scratch the trade, or take the risk. Using counterfactual thinking and coming up with ways to lay off the risk defeats the purpose of the exercise don't you think?
@TheShrike In this case case he said there was X% chance of quadrupling and Y% chance of losing then it means either (1) he wants to convey this is a very good trade but why the disclaimer? or (2) he knows the true distribution of returns or (3) he lies. We will ignore 3 because it wasn't part of the original information.
He says "your current trade" but only repeatable events can have a probability. It means there must be both a 100% certainty that you can quadruple your wealth if you hold the trade and a 100% certainty that you will lose it if you hold the trade beyond triple beyond your net worth. The only variant in this case is your free will and what you decide to do. This is the only information the time traveler doesn't have. As such, I would hold the trade until a few percent below quadrupling my wealth and then close it.
In addition, if I am allowed to trade the options, I would also open a huge risk limited bet on volatility. However, I would be sure to risk less then my net worth so it that it could not have impacted the information he imparted on me. I would also be sure to open it as a "new trade" so that it would not be subject to the prior.
