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Why do you sometimes not suggest opening positions for moves you perceive as highly probable?

October 19, 2012, 12:00 PM Przemysław Radomski , CFA

Sometimes you are pretty sure about a price move but at the same time don't suggest a speculative position or even discourage opening one. So how is this really? Are you really sure of the move (then suggest opening a speculative position) or are you not sure and that's why a speculative position is not suggested?

Probability is one thing and the expected size of the move is another one. It could be the case that while the probability of a given move is significant, the perceived (our assumption) size of the move is too small to justify opening a position.

(On a side note, that's why these are the factors we take into account in the Position Size Calculator - the tool that will tell you how many options of different maturities it makes sense to buy at most with a given price move in mind.)

Here's a thought-provoking example: if we believed that there is a 70% probability that the market would move 1% higher in the following 2 weeks, but at the same time there was 30% probability that it would decline 20% in these 2 weeks, we would suggest shorting the market with a very small amount of capital. We would probably lose this trade (70% probability), but we would lose a very small amount of capital. That's right - we would suggest shorting the market even if the probability of winning was only 30%.

As trading is not a one-time event, but a process, there would be a time when we are faced with a similar situation. We would once again short. We could lose again, but again a very small amount of capital. On average as this situation would repeat itself we would lose 7 out of 10 trades (70% probability of losing). However, the 3 times that we would actually win, would make us so much money that we wouldn't even care about the 7 losses. If one aimed for winning most trades, they would lose money over time - shocking, isn't it? The focus always has to be on making money in the long run, not on winning or losing one single trade. The problem is that it's counterintuitive and tough emotionally. By following this approach we will also get many messages from people who believe that constant winning trades are necessary for making money in the long run, and who believe that we're not doing a good job.

For instance, being prepared for a major plunge in precious metals prices earlier this year was this type of situation. Thanks to this approach when the major top in metals (and a subsequent major plunge) does materialize, we will probably be ready for it and that is when this approach will pay off big time.

However, until that takes place, we risk losing subscribers when they become upset with us after missing part of the rally. In fact, we're sure that if we never suggested getting out of the long-term investments, we would have more subscribers at this time. This being the case, we consciously accept the fact that we will bear the cost of this approach (those who resign from our services after being unhappy will probably not rejoin after metals do plunge as they will not be aware of our analysis at that time) in order to maximize your long-term rate of return. We simply care about you too much to give you less than what we believe is the best approach, even if we can make more money doing so. Being ethical costs, but this is the only way that we will provide our services.

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