Don’t even think of buying or selling without having realistic expectations of what can go wrong and just as importantly, what can go right. Here is another intersection of game theory and trading. Without a proper exit strategy you can let the two of the worst game altering forces enter the equation; Greed and Fear. These two forces will alter your probabilities of success. Game theory counts on rational participants. You need to remain a rational participant. Once greed and fear enter the picture most hope of remaining rational goes out the window. Set your targets and respect them.
Remember that when you enter into an investment, you are speculating on a direction and magnitude, just like guessing the wind. You are in effect playing a game and you need to understand how to react when winning and losing. This means understanding the risk you are taking with an eye to how much reward you can expect. Let’s look at an example to clarify:
When you enter the trade you should take a guess at your probability of success. Use whatever method you like, the point is to make a choice. Look before you leap. Let’s say you are fairly confident that stock XYZ is going to go up. You are considering buying it at the current price of $105.00. You might say it has a 70% chance of going up in price. Maybe the stock has gone down in price everyday in the past few days and you simply believe that it can’t go much lower. Maybe you are right, maybe you are wrong, again the point is you have to put some numbers to your thought process. You came up with 70%. Now think about how much you might be able to profit. Is it $5, $10, $20? How long are you willing to wait to make that profit? Try to have a realistic expectation. How do you arrive at these expectations is a topic for another day, for argument’s sake let’s assume that you think you can make $5 in two weeks. Let’s also assume that you do not want to lose more than $5. You now have most of the information you need to form your game plan.
Winning side: 70% chance of making $5 in two weeks (this comes from the above assumptions). Using simple probability concepts you can think that the expected outcome of your assumption is 70% chance of success multiplied by the $5 profit you think you can make. The expected value is $3.50.
Losing side: This also means that the 30% chance you might have of being wrong multiplied by the $5 you are willing to risk gives you an expected value of -$1.50.
So from a game perspective you have an expected profit of $3.50 and an expected loss of $1.50. You have given yourself a time frame of two weeks. What you have just done is given yourself an outline at how to look at your trade with a somewhat objective perspective. You can come up with the following game plan for the next two weeks:
- Take Profits (Sell the stock if it goes above $108.50, $105 purchase + $3.50 expected profit).
- Cut Your Losses (Sell the stock if it goes below $103.50, $105 purchase – $1.50 expected loss).
This is not meant to be the end all or be all way to come up with a game plan. There are many different ways to react to price changes. There are ways you can structure your trade to profit more or perhaps lose less with limit, stop, and/or trailing orders. The assumptions, such as the probability of success, are open to an infinite number of alternatives. The moral of the story here is that you must have at least thought these things out and given yourself some rules to act upon. Don’t succumb to greed when the price goes up in your favor. Don’t succumb to fear when the price goes down against you. Act according to your game plan. The more times you behave in that manner, the more times your trading process will lead to positive results. Behave like the casino, not the gambler. There is a reason casinos have set rules for every game and the gamblers usually don’t. The casino behaves rationally every single time. The gambler doesn’t. Who lasts longer? Do the math. Have your plan ready.
Good luck and trade rationally