Can You Lose All Your Money On A Sure Thing?
Monday, September 14th, 2009Doubt is uncomfortable, certainty is ridiculous – VOLTAIRE
What if we knew for sure that the Philadelphia Eagles would beat the Carolina Panthers yesterday, and that we were also certain that they would beat the betting spread? Any wager we made would pay off. Betting on a “sure thing” would be equal to a profitable outcome. Of course this assumes that your bookie pays you.
On the other hand, what if the “sure thing” was not a single event, but a series of events that still had a mathematical certainty of winning? Would that be equal to a profitable outcome like the Eagles bet? The answer is not necessarily.
In a recent presentation, author Max Barry, used a rather simple coin toss to illustrate how you can still lose on a “sure thing”. We all know that the probability of seeing a head is 50%, and a tail the same. To make sure it would be a mathematical “sure thing,” Max gave an edge to the head’s side.
So the game is this: The cost to flip is $10.00. If you flip a tail you lose $10.00, but if you flip a heads you win $10.10. Mathematically speaking, we now are in a position to win 5 cents every time we flip. That’s five dollars for every 100 flips. So, do you want to play?
Most people would say “sure, how can I lose?”, when they should ask “how much money do I have to bet?”
If you only had $10.00 to play with, then you are almost certain to lose. If your first toss is a tail you are bankrupt. Even if you had $100.00 you could lose in a series of 10 straight tail flips. In probability theory, the Kelly Criterion, is a formula used to determine the optimal size of a series of bets. Max points out that the Kelly Criterion is $2,000.00 in order to maximize the long-run growth rate of the bankroll.
So I guess we can say that our bankroll plays a big role in our success or failure. We know the more we flip the greater the probability of seeing an equal distribution (50/50), but, along the way we are subject to streaks that could break us. We need to have a large enough bankroll to battle the bad streaks and insure the long run. Even then there are no guarantees.
It is even more critical to have your trading system well capitalized for these same reasons. In fact, more so, because the trading system is never going to be as mathematically sound as the game above. When trading a system, there is no worse feeling then being pushed out at a low point only to see down the road a recovery to new equity peaks.
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