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I came across this article on slashdot about card counting and realized that that card counting might be an understandable analogy for many people of why effective risk is all that matters and how that can affect your money management strategy, as discussed in the 'More contracts == less risk' thread.
In card counting you shift the odds in your favor by counting the remaining cards in the deck, so you know if there are many high value cards remaining in the deck and the dealer is showing a low value card your probability of winning is much greater.
So although you can say that a card counter and the guy sitting next to him at the table are both risking all the money they bet on each hand. Effectively, the card counter has lower risk because he is less uncertain about the outcome. Moreover, as the card counter continues playing he can increase or decrease his bet based on his level of uncertainty.
The money management strategy I use, as described in the 'More contracts==Less risk' thread, is based on the same principle. In trading we actually have it much easier than card counting, in card counting you have to continually bet small amounts even when the odds are not great otherwise you will be kicked off the table or detected very quickly. In trading you can wait until the uncertainty is low and the odds are stacked in your favor to enter a trade and even better if new information reveals that your analysis may have been wrong you can effectively pull your money off the table (often with a small amount of profit as well).
The only thing you have to be able to do is come up with a way to evaluate the probability of a move in one direction vs. the probability of movement in the other direction to determine the uncertainty and then define some conditions for entering a trade when the odds are stacked in one direction. That is not exactly trivial but it is really not very hard either IMHO, all it takes is enough screen time watching the market action and understanding why markets move the way they do (ie understand the techniques of operators, market makers, how the order book works etc..)
Understanding how to evaluate uncertainty and control exposure to risk in this way is the only thing that seperates the card counter making millions from the guy sitting next to him who is lucky if he breaks even..
But what in trading makes gives you better odds on one trade versus the next. Regardless you are still piling on more initial monetary risk when you initiate the trade with the additional contracts.
I'm not trying to be stand-offish (is that word supposed to hyphenated, I dunno) just putting out there what's on my mind.
I suppose I just don't necessarily agree with the idea that having more contracts reduces risk, in fact I believe the contrary. However, I would agree that using more then 1 contract allows for a strategy of pursuing runners but this does not alleviate the initial risk management responsibility when the initial trade is placed.
The title of that thread 'More Contracts == Less Risk' is somewhat misleading to people I think.
It should be 'More Contracts -> More Control => Less Risk Exposure'
ie More contracts gives you more control which you can use to minimize your risk exposure
The reason I compare it to card counting is because in card counting you bet big when you know the odds are stacked in your favor, ie you scale your position size based on the current level of uncertainty/risk.
That implies that in order for this to work you have to have a good strategy, since by definition a good strategy should only act when the odds are favorable. Ie you only take low risk trades knowing that sometimes your analysis will be wrong and the trade will turn against you. So you close some of the positions early to cover costs and take small profit to create a safety net in case you have to stop out the other orders.
If you are taking trades that get frequently get stopped out (or have frequent large MAE) before you hit your cost/breakeven target then you have a bad strategy you need to work on identifying when NOT to trade
After reading my first post again I realize I worded some of it badly..
The way its worded it seems to imply that you can know your exact risk beforehand in card counting.. that is not true. You can quantify the risk but that is done before all bets are placed, after the first card is dealt the risk necessarily changes based on the new information that is available. So the best you can do is estimate the risk you will face, still.. that puts the card counter at a huge advantage.
In trading it is the same situation, that is ultimately the point I was attempting to make. When I said that a good strategy should only take trades with favorable odds, I meant taking setups which have proved to have favorable odds in the past. The point of having the cost covering orders etc as a safety net is that you can continually evaluate the risk as new information unfolds and you can get out of the trade safely if it turns out that the setup was invalid.
Imagine how easy card counting would be if you could take your wager off the table if a card was dealt which increased your risk..
Hi all,
The concept " More contracts==Less risk " is the greatest money maker. Unfortunately many traders do not understand this concept. This statement is true only if a correlation between trades is less than 1. If the correlation is -1 or close to it than it is more profitable even to add a loosing strat to some winning strats.
An example (its not mine example):
You toss a fair coin.
Strat 1: Tail you win 4$ and head you lose 1$.
Your winning expectancy = 4 * 0.5 - 1 * 0.5 = 1.5$. You see that this is a profitable strat. Still you can lose your account in a rare case.
Strat 2: Tail you lose 3$ and head you win 2$. This is a losing strategy.
Now calculate what will happen if you trade them both.
In a situation of a correlation of 1 you don't lessen your risk at all. Like trading 3 contracts with the same stop and same profit target.
Now the question is what is a correlation of your trades.
If you enter a trade with several contracts and scale out the correlation is quit big. If you trade the same setup on the same instrument on different time frames, the correlation is less, but still substantial. Then you can trade the same setup on different instruments of a same sector (indexes, currency, etc..). Even lesser correlation is if you trade on different sectors, and so on.