Why Traders Need To Focus on Asymmetric Returns 3
For a modern parallel to Newton’s misadventures in financial markets, think of Bitcoin’s sharp rise, and subsequent tumble.
Bitcoin rose sharply over 2017 – 2018, and topped out at just below $20,000, then proceeded to crash. Another meteoric rise followed in 2020 that peaked near the end of 2021 at around $68,000.
While stories of crypto traders who have made millions (or even billions) abound and draws even more people into the craze, there are many more folks who have traded Bitcoin in much the same way as Newton did during the South Sea bubble.
These traders either made a fortune and lost it plus more, or just lost their shirts without making a fortune at all.
The reason we only hear of those who made huge profits is the survivorship bias; people who lost big are simply forgotten or not discussed. After all, who goes around bragging that they lost a fortune?
It is important to note that all of this is extremely clear to us today because we are looking at the price chart with the benefit of retrospect. When we are in the midst of a market bubble, or a trade that has started to finally rack up asymmetric returns, it is impossible for us to know when prices have reached their zenith.
Consequently, in order to not fall prey to the disposition effect while trading to make asymmetric returns, we must trade in a fashion that works to mitigate the disposition effect, as detailed here.
On a broader level, astute readers would note that all of this sounds very similar to the concept of convexity, and how it applies to markets and real life. That is, to pay a small fee in return for a large payoff; and that’s because it is!
Trading for asymmetric returns is, at its core, an exercise in going long convexity in order to exploit the Paretian nature of markets.
More importantly, as the examples of Newton and Bitcoin so clearly illustrate, financial markets have always produced opportunities which generate asymmetric returns.
Regardless of the form they take; an old fashioned stock market bubble and crash, a housing bubble/crash, banking crisis, or hyped up new technology, all involve the same combination of greed, fear, and the opportunity to make, or lose, a life changing amount of money.
Unfortunately, while everyone wants to make a life changing sum of money, trading bubbles and crashes, or pursuing asymmetric returns in general, is a very difficult endeavor, again clearly illustrated by Newton and Bitcoin.
However, if done well and consistently, such an approach can, over time, produce significant returns, although requiring tremendous discipline, emotional control, and mental stamina.
Nothing is ever easy in life, much less trading the markets profitably. Give yourself as much of a chance to succeed as possible by starting on the right foot with a well constructed trading plan.
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