You might have always heard that low risk levels are associated with low potential returns and high levels of risk are associated with high potential returns.
But this blog intends to stand against the traditional concept of Risk=Reward.
There is a possibility that a person even while holding less risk can achieve high returns
Wondering how is that possible???
Yes, it is !!
Also Read : Is the Stock Market similar to arranged marriages?
Let solve this puzzle with the help of an experiment using coin flips and probabilities:
We assume that we are not a market expert and we may exit from our trade in profit or loss with 50-50% chances. Same is the situation in betting for head or tail by flipping a coin.
Therefore we consider betting on the flip of the coin to be similar to investing in stock market. But with a bit of optimism, we believe probability of Head = 0.51 and probability of tail = 0.49.
We have with us $1000 and for every Head we win 100%, Tail we lose 100%.
We have two choices
1. we can play 1 bet of $1000
2. we can simultaneously play 1000 bets of $1 each
Which one would you opt for? Why?
Let’s find out an optimal solution to it …
Calculation of Reward
Single bet : 0.51* $1000 + 0.49* (-$1000) = $20
Multiple bets: 1000 * (0.51* $1 + 0.49* (-$1)) = $20
We can now say from the above calculation that the expected reward in both the cases is the same i.e. $20 in both the cases.
Hence we hold the same rewards. But what about Risk? Should it be same or different?
Let’s work on measuring the Risk associated with each of them
Risk Measure 1: Probability to loose everything
Single bet: Probability to loose everything 49%
Multiple bets: Probability to loose everything= 0.49 X 0.49 X 0.49 ……0.49= 0.49^1000(very small)
Risk Measure 2: Standard Deviation
Single bet: computing stdev(1000,0,0,0,0,0,0…… )= $31.62
Multiple bets: computing stdev(1,-1,1,-1,1,1…..-1)= $1
Single bet: Reward/Risk = $20/$31.62=$0.63.
Multiple bets: Reward/Risk = $20/$1=$20.
Isn’t there is a big difference!! We achieved similar rewards with significantly less risk.
Also Read : Fibonacci Numbers: How important are these for Trading?
Hence its always better to invest small amount with more number of bets rather than single bet with big amount. This helps in reducing your risk of losing entire amount at once and get better returns too.
(Source: Dr. Tucker Balch, Georgia Tech University)
We hope this blog will help you to achieve your financial goals in a smarter way.
We encourage you to share your ideas and thoughts and leave comments/questions so that we can all learn from each other.
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Hi Sahil, you can refer to these links: https://tradesmartonline.in/blog/options-strategy-straddle-and-strangle/ and https://tradesmartonline.in/blog/factors-determining-options-pricing/ these will clear your doubts. 🙂
Can you please elaborate in context of options ?
Thanks. Apologies for the delayed reply. Somehow we did not receive an email notification for this and hence missed your comment. Will look into the same.
Glad to know you liked it. We’ll keep writing more useful stuff. Hope you find that too useful.
It was really enlightening to read this. I never thought of this logic.