The Risk Management Paradigm is the most important
aspect of not only Day Trading, but Futures
Trading.
The following video is an excerpt from our
Academy and it explains a dice game that illustrates
the paradigm shift that needs to take place
in order to view situation from a risk perspective.
Casinos make millions of dollars, even billions
of dollars with the principles we're going
to examine.
Day traders make millions and billions of
dollars with this secret as well.
Since dice has six sides, the following odds
apply: the odds of rolling a six, is one in
six; the odds of rolling anything other than
a six, is five in six; the odds of rolling
a one or a six, are two in six, or thirty-three
and a third percent; the odds of rolling anything
other than a six or a one, are four in six,
or about sixty-six point six six percent.
Now that we the odds of rolling dice, lets
take a look at a scenario.
Lets say i tell you im going to give you one
dollar if you roll a six, but im going to
take a dollar if you roll anything else.
Youre odds are one in six to make a dollar.
Would you take that bet?
Obviously your answer is no.
It's crazy to take that bet.
If you roll a hundred times, you'll win only
sixteen dollars and sixty-six cents.
We arrived at that number by multiplying a
hundred by one point six six six seven.
You would loose eighty-three dollars and thirty-three
cents, so your net loss would actually be
sixty-six point six seven.
So lets change the rules of the game a little
bit and talk about scenario two.
I'm going to give you nine dollars if you
roll a six, but take a dollar if you roll
anything else.
In this case, your odds are still one in six
to win, but you win nine dollars instead of
one dollar.
Would you take this bet?
The answer is probably yes.
Within one hundred rolls, you would win a
hundred and fifty dollars, thats multiplying
a hundred rolls by point one six six seven,
and then multiplying that by nine.
But you would only loose, eighty-three dollars
and thirty-three cents.
Your net gain for every one hundred rolls,
would be sixty-six dollars and sixty seven
cents.
But wait!
Lets say you only have five dollars in your
pocket and you need this money because you
haven't eaten dinner in two days.
Would you risk that five dollar dinner money
in order to make nine dollars?
When you only have a one in six chance of
winning?
Probably not.
The fact remains that you simply can't afford
to roll enough times for the one in six odds
to even out.
So it may be wise not to bet until your bank
roll can afford to balance out the odds.
In statistics we call that balance the normal
distribution.
With the additional variable of reduced capital,
and increased risk, we evaluate the scenario
through the eyes of risk, and decide that
the risk outweighs the reward.
You simply cant afford to risk that five dollars
for a one in six bet.
Lets take a look at scenario three.
Lets assume in this new scenario that we increase
the odds of winning that I tell you that we
roll a one or a six, I'll pat you four dollars
and fifty cents.
But if you roll anything else, I will take
a dollar twenty-five.
Before we discuss this scenario lets do the
math.
For every one hundred rolls, you will win
one hundred and fifty dollars.
We arrived at that number by multiplying one
hundred by the odds of thirty-three and a
third percent of you rolling a one or a six,
times four dollars and fifty cents.
In this scenario, you will loose eighty three
dollars and thirty-three cents, we arrive
at that number by multiplying one hundred
by sixty six point six six seven by a dollar
twenty-five.
If you compare scenario two and scenario three,
wow!
You'll win exactly the same amount of money.
The question is- which is better?
Scenario two or scenario three?
The answer to that question is not obvious
until you apply the secret of risk management.
all too often, traders see scenarios that
look the same because they're looking at the
situation from the "What can I win?"
point of view.
If they look at it from the "What can I loose?"
point of view, the overall picture becomes
clear, and they can save some of their profits
and reduce their losses.
This simple dice game was just one example
to illustrate how a defensive perspective
is needed to understand risk management.
In live day trading, you need good money management
methodology and a mentor to show you all of
the applications of risk management to be
successful.
If you'd like to sit in behind the scenes
with the Trading Group, call eight eight eight,
six four six, eight seven eight seven, or
go to SP500Trader.com.
