Risk & Reward: How Financial Speculation Can Deliver Stunning Rewards

30th November -0001

Financial speculation is defined as buying (or selling) an asset based on the idea that a price appreciation or depreciation is imminent, with the risk of losing some or all of your money on each transaction. While it’s normal to become fearful when you think about losing money, with some common sense practices and by establishing a system for yourself, you can minimize and, in fact, limit this risk. In this article we will look exclusively at company stocks or shares that are publicly traded on the Colombo Stock Exchange because listed shares are probably the easiest, most accessible way to engage in financial speculation.

 

Financial Speculation or trading stocks differs significantly from investing in stocks because as a speculator you will not be buying value nor will you be buying to hold for the long or even the medium term. The sole aim and goal of speculation is to grow your starting capital by taking small, repeatable risks in the market.

 

When trading stocks or making any kind of financially speculative move it is essential that you understand these four key elements: Risk, Reward, Probabilities & Edge.

 

Risk is the possibility of losing an amount of money. Reward is the possibility of making an amount of money. Probability is the likelihood of one particular outcome occurring over another based on a large sample size of outcomes of similar transactions. For example, if you toss a coin a thousand times you will likely get an even number of heads vs. tails or a 50% probability of either outcome. This means that in a scenario where you are tossing coins and based on the outcome you will either lose or gain one unit of money, you have no edge, meaning that over time you will neither lose nor make any money.

 

Now consider a scenario where you are sitting at a T-Junction. Cars approaching can turn right or left. However, the road to the left leads to a major shopping complex and the road to the right leads to a farm. Now imagine risking 1 unit of money on cars turning either left or right. Consistently putting your money on the cars turning left will give you an edge, because even though you will lose 1 unit of money when cars turn to the farm, many more cars will turn to the shopping complex than the farm and over time you will make money.

 

Another way to gain an edge is to ensure that every time you lose money you lose only 1 unit of money but every time you make money you make more than 1 unit of money. This is then called a Risk-Reward ratio. For example, if you risk 1 unit of money to make 5 units of money, meaning that every time you lose you lose 1 unit but every time you make you make 5 units of money, you can afford to be wrong 70% of the time and still make money over time.

 

These principles can be applied to any kind of speculation and there are many ways to go about it. Let’s look, however, at stocks and a simple but effective strategy to achieve outsized gains over time.

 

The best kinds of stocks to look at are ones that have formed a ‘price base’ i.e a narrow price range for a long time after a significant period of declining prices. Then watch these stocks and buy them on any upward price expansion outside the ‘price base’ if accompanied by very much higher than average trade volumes. This strategy allows you to minimize your risk by selling for a small loss if the price does not continue upwards and instead sinks a back into the ‘price base’ or worse takes a look at further downside. However, if the price moves in your favour you can expect to gain 3 to 5 times the amount of money you risked initially.

 

Given these outsized returns and the fact that price expansion when accompanied by sharply increased trade volume results in a very high probability for continued upward price movement, the consistent application of a simple strategy such as this can yield handsomely.

 

When speaking about risk it is important to think in terms of percentages and never to risk more than 1 to 2 per cent of your total trading capital on a single trade. This figure might seem small but the following table will make clear why it is so essential to take small risks, consistently in order to be profitable over time.

 

Percentage of Loss Percentage Gain Needed To Recover Loss
-5% 5.3%
-10% 11.1%
15% 17.6%
-20% 25%
-25% 33%
-30% 42.9%
-35% 53.8%
-40% 66.7%
-45% 81.8%
-50% 100%
-55% 122%
-60% 150%
-65% 186%
-70% 233%
-75% 300%
-80% 400%
-85% 567%
-90% 900%

 

This is why it is essential to minimize your exposure to risk and this is achieved by first deciding at which price point your initial speculative idea will be proven wrong and then selling out for a loss without fail if the price reaches that point. Once you have decided this, based on the market price of the share you can then decide how many shares to buy so that if things go bad you will lose only a predetermined amount that should not exceed 2% of your total capital. It’s important to remember that this does not mean that you should only use 2% of your capital at a time. This 2% figure is only about how much you’ll lose in case things don’t work out.

 

These principles of risk, reward, probabilities & edge are applicable to all areas of speculation and life. For example, when you get into your car to go to work you’re risking your life for the reward of getting to work quickly and on time in an atmosphere of extremely low probability of anything actually happening to you during your commute and this gives you an edge, which is the ability to get more done in a day than just travelling to and from work.

 

In the next article we’ll go further in depth about how to responsibly engage in financial speculation with stocks including how to get started, how to size positions correctly, liquidity and some basic strategies that work over time. Until then, even in life, take small risks for big rewards when the probabilities are in your favour.