Basic Risk to Reward
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This article includes:
- What is risk and reward?
- How the odds affect risk and reward
- Casinos: the odds are NOT in your favour
- Trading is not gambling: shifting the odds in your favour
What is risk and reward?
Risking your hard earned money has to have a reward to it, or else why would you be in the trade? First we have to identify what risk-to-reward actually is. Basically, you want to limit the risk of a negative event, and you want the reward to be worth that trouble or risk.
Risk management was discussed in my last article. I will use the same examples from that article to delve more into risk and reward.
Putting on your seat belt is a way of managing the risk of a car accident becoming fatal. Why do you take the risk of getting into an accident in the first place? It could be to drive to the store to get groceries, or get to your job to make money to provide for the family. The chance of a car accident is the risk. The groceries, or the job, are the reward. You risk a car accident, limiting your risk for serious injury with seat belts, to get the reward of food or keeping your job.
Getting a yearly checkup at the doctor is to ensure your health. Why? Because the reward of good health and living longer is worth the small risk of the doctor making you uncomfortable.
You even consider the risk-to-reward in normal everyday transactions, when you consider whether something is worth the trouble or money. An example would be if movie tickets were worth $100 apiece. If a typical movie is 2 hours, you might not want to risk $50 an hour if the movie (the reward) isn’t phenomenal. This is why movie tickets are closer to $10–20 each, because it is easier to justify two hours of entertainment for that price. Let’s not even talk about the prices of popcorn or drinks at the theatre….
This same logic is applies to every trade you consider taking. What sounds more appealing? Risking $100 to make $100,000, or risking $100 to make $1? The first one, obviously. With this example, we can even break it down into a fraction, called the risk-to-reward ratio.
$100: $100,000 = $100,000 / $100 = 1000
1: 1000 = Risking $1 to make $1000
The ratio is what matters, because everyone’s capital is different. And what’s a ratio? A fraction, which can also be described as a percentage. This is why I continue to emphasize thinking in percentages rather than fixed amounts. People get caught up in how much, say, 10% means in $$$, but that is fully dependent on the capital. In the example above, the risk-to-reward ratio can be described in a few ways.
RR = 1000
Risk to Reward is 1 to 1000
RR = 1: 1000
1/1000 = 0.1 % risk
How the odds affect risk and reward
Of course, a 1: 1000 risk-to-reward ratio sounds really appealing. There has to be a piece of the puzzle missing, because why wouldn’t everyone be using the 1 to 1000 model? Let’s consider a lottery, where you risk buying a $5 ticket for a reward of $50,000 or more. Lotteries have much higher risk to reward numbers, some even offering $1: $100,000, where you buy a $10 ticket for a chance to win $1 million.
You might have already guessed what is missing from the risk-to-reward ratio. The last piece of the puzzle is the odds or chances of that event actually happening. The reason many people lose money on lottery tickets is because the odds are not in their favour, and this balances out the large reward.
Another place where odds are not in your favour is the casino. Many people consider trading to be gambling, much like the casino. I disagree, solely because in gambling the odds are never in your favour. With trading you have two differences: the odds can be in your favor, and you trade for an actual asset. (In some versions of trading you do not actually have the asset traded, but that will be in a later article and is definitely not needed right now.)
I’ll digress a little bit here to talk about casino games and how they’re rigged so that you are unlikely to ever win, but I promise I’ll tie it back into crypto trading, and how you can rig it so that the odds are much more in your favour. Bear with me as I put on my tinted green visor….
Casinos: the odds are NOT in your favour
Here are some odds of casino games for reference.
Roulette
Blackjack
Poker
You can see that casinos are rigged so that the house is always at an advantage. Every single game is made in a way that you cannot manipulate the win rate or the risk-to-reward rate in your favour. One example is the casino limiting tables to certain money limits. Let me explain how this ensures that the odds are against you in roulette.
Roulette involves spinning a wheel divided into numbered sections and then rolling a marble around the outside in the opposite direction. Eventually the marble loses momentum and rolls into one of the divisions. Before the game begins, you can bet on the number or the colour that the marble will land on, with varying degrees of complexity (see the table above).
Without getting into specifics, here is how the casino ensures they are more likely to win than you. First, there are only two colours to bet on: red and black. This should put your odds at 50: 50 if you’re betting on colour; however, they add an extra green number or two. Now the odds aren’t 50: 50; they are 47: 47: 6.
However, it isn’t even the chances of winning that are the problem; it is actually the payout. In roulette, you only get paid out 1:1 when you bet on a colour, meaning that for every $100 you put in, you only win $100. Risking $100 to make $100 means you need to win 50% of the time to just break even.
Since the odds of winning are less than 50%, you are almost guaranteed to lose over time. So how could you rig roulette in your favour?
It’s simple. You have to bet more and more until you do win, doubling down every time you lose.
Why do we need to do this? So that when you finally win, the return rate is worth it. Here’s how it works mathematically.
Since you know you are going to lose more often than win in roulette, you can stagger your bets, meaning betting more and more until you finally win. That one final win has to cover any previous losses and hopefully let you come out ahead. The simplest way to do this is to double down every time you lose. The table below shows how you only need one win to make up for all of your losses with some cash to spare. After you win, you must reset because you don’t have unlimited capital…but if you do, please send as much as possible to this address…<just kidding>.
For the example above, I have indicated an initial capital of $1000. Each round starts with a bet of $20, doubling down after each loss, and resetting back to the original $20 bet with each win. While each individual bet gives you a 47% odds of winning, over time the odds get stacked. What are the chances of you losing 5 times in a row with 47% odds? Essentially 2%: 0.47 x 0.47 x 0.47 x 0.47 x 0.47. So after 5 rounds, your odds of winning at roulette are now much better: 98%. You’ve rigged the game in your favour!
One response that I often get is this: “But the win rate is 47% every turn. The previous turns aren’t calculated in the future win, so how can my odds of winning go up?” Yes, it’s true: neither games of chance nor the trading market care about your previous wins or losses — your odds of winning or losing each time don’t change. But the odds of consistently winning or losing over time (a winning or losing streak) can and do change, which is where the 0.475 calculation comes in. An even simpler example is flipping a coin. Your chance of getting a heads is 50% on each flip, but your chances of getting heads 5 times in a row is much lower: 2.5% (0.505)..
You have to think about these 5 rounds of roulette together because you are expecting to lose. This is why you double down each time, starting with a modest fraction of your capital, rather than betting a larger amount with the hope of winning immediately. You have to accept that there is a chance to lose, which is why you don’t want to use your entire capital.
If you have a 98% chance to win +34% of your capital after 5 rounds ($1000 starting, 4 losses, 1 win, up to $1340), then why aren’t people getting rich at casinos?
The casinos know these statistics too, and they place table limits for this reason. The rationale is to make it fair for people (and save them from themselves), so they will normally limit the table to only allow you to double down 2–3 times in a row. A typical roulette table, for instance, is about $20-$120. This means if you start at $20, you can double to $40, double twice to $80, but then cannot double down any further. Your odds of losing after three rounds is 0.473 = around 10%, which is much better statistically for the casino. This is how the casino keeps the odds in their favor.
Trading is not gambling: shifting the odds in your favour
At this point you might be wondering how this relates to trading, and the answer is this: there’s nothing stopping you from applying this method, called the Martingale strategy, on trades. The Martingale strategy is similar to the dollar cost averaging method (DCA).
These two methods are important to know and understand. They are basic ways of entering and exiting a trade safely and increasing the win rate in your favour. In roulette, the casino limits you from increasing your win rate (over time) by setting table limits to prevent you from doubling down and increasing your odds of winning over time. In trading, there are no table limits. You can DCA and Martingale as much as you want, with as much capital as you can use.
That is one of the reasons why trading is not gambling in my mind. In gambling you cannot turn the odds enough in your favour, but in trading you can. Another reason it is not gambling is that you trade money for the coin or asset rather than placing money on the table and getting only a chance in return. Sure, the exchange technically has the asset until you place it in your wallet or hands, but that’s better than getting literally nothing.
When you buy $100 of ETH, ETH needs to drop 100% for you to lose $100, and there is a 0.1–99% chance of that happening within days, months, or many years. That sounds really variable, but with the right tools and strategies, you can mitigate the risk of losing the entire $100, and no matter what the outcome, you have a coin to hang onto or trade away. When you place $100 on the table in roulette, it is traded for nothing but a 47% chance to either double your money or get nothing, all within minutes or seconds, with no way to manage the risk and nothing to show for it if you lose. Who would ever gamble when they could trade instead?
In the next article, I’ll discuss how to use trading strategies to minimize your risk, maximize your reward, and use the odds in your favour.
Takeaways
In this article we looked at the idea of risk to reward and how odds and percentages can work for and against you.
- Trading is not gambling: shifting the odds in your favour
- Any risk has to be worth the reward.
- The odds of winning will affect how your risk-to-reward scenario plays out.
- Lotteries and casinos have bad odds.
- The odds in trading can be shifted in your favour using the Martingale and DCA strategies.
