Original publication of this article was on http://www.BazaarAnalysis.com and it was written in the context of intra day/Swing traders. However, core principles are even applicable to any kind of trading at stock market.
Is Stock Market Gamble?
The answer for the above question is YES and NO both. Non-ambiguous version would be depends. So, the next question would be what are the dependency factors? To find out this answer we will first focus on the question, what is gambling? Whatever definition comes to your mind, on the basis of that definition try to answer which one of the following comes in gambling and which does not?
1. A person opens a shop at cross junction near your house with the hope that he will find customers from the surroundings.
2. Preparing for civil services exam.
3. Bungee Jumping
4. You are going out without umbrella because right now it is sunny (actually you are not expecting rain)
5. Buying lottery ticket
6. Playing roulette (Kind of casino game)
A wild guess puts most of the folks to identify playing Roulette is gambling, for some folks buying lottery tickets too and rest of the answers can be anything. Now let us have a close look at what are the essential common factors involved in all of the above activities.
1. Risk (Loss of human life and hard earned money is considered as potential risk in this context)
2. Reward (Monetary or wide social recognition)
3. Chances of favorable outcome
So, let us categorize them according to above factors
|Activity||Risk||Reward||Chances of favorable out come|
|Opening a shop at cross junction||Moderate||High||High|
|Preparing for civil services exam||Low||High||Could be ‘High’ for a hardworking person with good academic track record|
|Going out without umbrella on sunny day||Low||Low||High|
|Buying lottery tickets||Low||High||Low|
|Playing roulette||High (assuming you are giving high exposure of earned money)||High||Low|
So, from the above table we can see there is a bit of risk involved in all activities. However, when reward exceeds risk and favorable outcome is high then normally we do not consider those activities as gamble. In case of gambling we can clearly see reward is not exceeding risk and favorable outcome is low. Sometimes numeric figure may delude reward risk figure. Like a betting of Rs.1000 for reward of Rs.100000 may appear like low risk high reward. What, if Rs.1000 is all your capital, in that case unfavorable outcome will lead you to bankruptcy. So, this is actually high risk and high reward scenario.
Let me explain the above concept in a different way. Suppose you are offered to play a game of dice with following three different setups:
Game 1: You’ll lose Rs.100 if number that appears on the dice is odd (1, 3, 5) while you’ll get Rs.100 for even (2, 4, 6).
Game 2: You’ll lose Rs.50 if number that appears on the dice is odd while you will get Rs.100 for even.
Game 3: You’ll lose Rs.100 if number that appears on the dice is less than 3 while you will get Rs.100 in all other cases.
Categorization of above three setups will look like following
|Setup||Risk||Reward||Chances of favorable out come|
|Game1||Risk and Reward Equal||Risk and Reward Equal||50% (Since out of 6 numbers on the dice, three are odd and three are even)|
|Game2||Low (loosing Rs.50)||High (Gaining Rs.100)l||50%|
|Game3||Risk and Reward Equal||Risk and Reward Equal||67% (since you’ll lose only when number 1 and 2 will appear else for number 3,4,5,and 6 you will win)|
Of course Game 2 and Game 3 are more appealing to play because you will end up profiting after several rounds of the game.
Assume you have played 30 rounds of each game. So, in case of
Game1: You’ll win 15 times (most likely) and lose 15 times.
So, net result will be 15 X 100 – 15X100 = 0;
Game2: You’ll win 15 times and lose 15 times.
So, net result 15X 100 – 15 X 50 = 750
Game3: You’ll win 20 times and lose 10 times.
So, net result 20X 100 – 10 X100 = 1000
Above example is giving clear picture if we work on high reward/risk and/or high favorable outcome (at least one of them) setup then we end up profitable.
Now let me map this concept to stock market. Basic activity in stock market is to trade and complete it by doing reverse process. If we have entered with buy decision then we need to end by cover sell and if entered with short sell decision then need to finish by cover buy. At the end of the cycle if buy price was less than sell price then we call it profitable trade else loss trade. Even an expert trader cannot assure every trade will be profitable. So, loss is part of the game. Only thing what one can control is amount of the loss. We call it stoploss criteria. We can fix an amount upto which we can bear loss for a trade. If it is not moving in desired direction then we should get out of the trade at stoploss price. This stoploss is the risk part of this game. To estimate the reward part and favorable outcome part we adopt several techniques. Like Fundamental Analysis, Technical Analysis, Quantitative Analysis etc.
These analytical methods which have roots in academic world, provide way to calculate potential gain based on various available parameters. Sometime we decide stoploss based on model suggested by these analytical methods. So, we can calculate numerically reward vs risk ratio. We recommend one should not enter in any trade unless this ratio is equal to or better than 3:1 . Keeping this minimum ratio on higher side has specific reason. In above calculation for simplicity purpose we have not included the charges imposed by game organizer (In case of stock market we call them Broker). Yes, brokerage and slippage (the price difference which goes against you when you trade at market price) may appear to be small at early stage but their impact is profound.
And last but not the least, money management is very important part of the overall process. In dice game we assumed Rs.100 is not a big amount so, risk is not marked as high. However, if amount in your pocket is just Rs.100 then what? You may get out of the game at first place. You have no opportunity to play 30 games to average out on statistical base. Even getting three consecutive odd numbers is not an impossible scenario. So, you have to decide how much money must be there in your pocket so that you can survive till fair number of games where statistics will start reflecting favorable outcome matching your estimate.
1. One should identify risk and decide stoploss criteria before entering in trade.
2. There should be logical and statistical reason to enter the trade which should give trader upfront estimate about potential reward. Avoid pseudo logical and statistical reasons to do trade. For that read our other article 6 Reasons Which Often Wrongly Influence One’s Stock Market Decisions
3. One should keep in mind that staying in game longer is more important than making quick money in very few trades. Even a trade which appears to be highly favorable but high risk (which may wash you away from the game) should be avoided.
So, if somebody is trading in stock market under discipline mentioned in above three points then it is not gamble and it is just like any other business (like opening a shop at cross junction).
However, if not following even one of the above rule it is gamble and that can lead sooner or later to very unpleasant situation.
APS (Active Portfolio Service) keeps stock investors compliant with all core principles discussed in this article in effortless way.
Did you like this article? Please share it with your social network