Why Traders Need To Focus on Asymmetric Returns 1

August 10, 2022

Why Traders Need To Focus on Asymmetric Returns 1

I can calculate the motion of heavenly bodies, but not the madness of people, Sir Isaac Newton Quote

Hang around traders or investors long enough and you will hear the phrase “asymmetric returns”.

While it sounds suspiciously sophisticated and impressive, “asymmetric returns” aren’t, like a lot of other financial jargon, pure marketing guff. They are, in fact, a reflection of not just how markets distribute outcomes (returns), but also how we can best profit from them.

Which begs the question, what exactly are asymmetric returns, and why are they so important?

Asymmetric simply means lopsided, or a shape that isn’t symmetrical.

The shape being referred to in this case is the risk/return profile, with the lopsided portion falling on the side of return.

Simply put, it means taking risks which offer the potential for outsized gains.

Since the risk taken is relatively much smaller than the returns on offer, the returns are asymmetric relative to the amount risked.

This is important because it directly relates to how markets really function, that is according to Pareto/Power Law distributions, and not, as widely imagined, Normal distributions.

Pareto distributions are asymmetric, with returns heavily skewed towards one side of the distribution, while normal distributions are symmetric, with returns evenly distributed into an aesthetically pleasing bell curve shape.

The Pareto distribution does not distribute outcomes symmetrically, like the normal distribution — *Pareto vs Normal Distribution from https://taylorpearson.me/luck/*

In essence, this means that returns from a financial instrument are inconsistent across time.

This is easily observed by pulling up any price chart, where, should the chart cover a long enough period of time, anyone can quickly see that prices spend most of the time in a range; that is, not doing anything.

In the rare periods of time where they aren’t range bound, they are either trending higher, or lower – sometimes doing so strongly.

These are the periods of time which generate meaningful returns for traders and investors, as prices are rising/falling quickly and by relatively significant amounts.

As such, traders have to trade accordingly to maximize their profit potential; taking advantage of times when markets offer the opportunity for making large gains, while keeping risk relatively small in order to avoid losing too much money when markets don’t.

In other words, trading in search of asymmetric returns.

Financial history is full of such trades, including the intrepid folks who shorted US subprime in the run up to 2008’s Great Financial Crisis – the trade made famous by the book (and later movie) The Big Short. More recently, we have Bitcoin’s meteoric rise from being mined but not traded in 2009, to trading at all time highs over $60,000 in 2021.

While many people tend to dismiss the folks who bought into BTC extremely early as being lucky, since no one knew beforehand that it would trade at such high levels, the trade is an excellent illustration of how to trade for asymmetric returns.

From a risk/return perspective, when BTC was trading for single digits almost a decade ago, the risk of owning them was negligible, simply because they were so cheap. At the same time, the potential for Bitcoin to generate outsized returns did exist, although the probability of it happening was low.

As such, buying into BTC back then, if seen from the perspective of risk/return, became a matter of asking “What’s the worst that could happen?”

If it doesn’t go anywhere, the total loss will be small, but if it does take off, returns could be astronomical; which is, of course, exactly what pursuing asymmetric returns is all about.

To be continued…