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Why The Law Of Large Numbers Dictates Effective Risk Management

Summary It is effective risk management that determines profitability rather than the incidence of wins to losses. The law of large numbers suggests that a larger number of trades with a positive reward to risk ratio will be more effective than a smaller number of trades. In this regard, it is possible for a trader to be “wrong” a majority of the time while continuing to remain profitable. “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros The entire dynamic of successful trading could probably be summed up in the above sentence. When I started out trading forex, I was overly concerned with getting the trades right. However, I have come to learn that the most successful traders are not the ones who are right all the time; rather they are the ones who know how to manage their risk most effectively . For instance, the odds that a plane will crash somewhere in the world are 1 in 11 million. Indeed, this is a very low probability. However, when one considers the vast number of flights that take off and land every day, it is sadly almost inevitable that there will be a plane crash at some point in the future. The odds of a golfer getting a hole in one are 5,000 to 1. However, across the world there are far more than 5,000 games of golf being played in a single day; it is therefore almost inevitable that a player somewhere in the world will manage to score a hole in one today. The above phenomenon is known as the law of large numbers ; where an event with a low probability of occurring on its own has a higher probability of occurring when subjected to a large number of trials. This has important implications for risk management, and moreover it demonstrates how a trader can still be wrong the majority of the time while continuing to be profitable. Let us take this as an example. Suppose that we have eight forex trades in a particular month, with a 1:3 risk-reward ratio, or a stop loss of 50 pips and a take profit of 150 pips. For each trade (discounting technical or fundamental factors), the odds are greater that we will make a loss rather than a profit. However, the profit on each trade far outweighs the potential loss. With a 1:3 risk-reward ratio, we have a 75 percent chance of the price hitting our stop loss with a 25 percent chance of it hitting our take profit ratio. However, this also means that only two of the eight trades need to be profitable for us to breakeven. Moreover, the law of large numbers dictates that at least two of our trades are indeed likely to be profitable. 1-(1-p)^number of trials where p is the probability of an event occurring In the above instance, we need at least three of our trades to hit the take profit point in order to be profitable. Given that we have a 0.25 probability of this happening, our probabilities are as follows: 1-(0.25)^1 = 0.25 1-(0.25)^2 = 0.4375 1-(0.25)^3 = 0.5781 1-(0.25)^4 = 0.6835 1-(0.25)^5 = 0.7626 1-(0.25)^6 = 0.8220 1-(0.25)^7 = 0.8665 1-(0.25)^8 = 0.8998 We see that with eight trades being placed, we have an 89 percent probability that at least one trade will hit our take profit point. Given that we need three trades to be profitable: 0.8998^3 = 72.85 percent probability of three trades being profitable In this regard, we see that the law of large numbers provides us with an attractive risk-reward set up in that it limits our downside while maximizing our upside. Moreover, we can be wrong more often than we are right and still remain profitable. One of the big reasons why most new traders fail is the inability to manage risk effectively. For instance, if we decided to set up trades with a high risk and low return, e.g. 150-pip stop loss and 50-pip profit, then even if we were right a majority of the time it would only take a couple of losing trades to wipe out our winnings. Ultimately, being a successful trader is not always about being right. It is about managing your risk effectively. As we can see, the law of large numbers plays a key role in doing so. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The SEC Is Going Too Far On ‘Clawback’

Summary Andrew Ross Sorkin of DealBook reported that the new SEC proposal could obligate all publicly traded companies to recover incentive-based compensation from executives contingent on certain events. If the proposal is passed, it would result in widespread ramifications for Corporate America. In this piece, I detail the potential negative consequences that I believe are the most salient to the discussion at hand. Ramifications would revolve around the misalignment of interests between shareholders and management. Increased compliance costs and reduced market liquidity would be possible consequences as well. Investors should consider allocating capital to international corporations not subject to SEC regulation. “Clawbacks” are coming Recently, New York Times DealBook founder Andrew Ross Sorkin reported that the Dodd-Frank regulation, which aims to overhaul the financial system post-2008 requires the Securities & Exchange Commission to devise a rule relating to “clawbacks”. As a quick reminder to readers who are not familiar with the term, clawbacks are provisions that are included in employment contracts which allow the principal (i.e. the employer) to limit bonus compensation upon the occurrence of certain events specified in the employment contract. Moral hazard and measures taken to mitigate the problem The reason why clawbacks generate a great deal of discussion is largely as a result of the sub-prime mortgage crisis. Public and political commentators have opined that one major factor contributing to the crisis was that of moral hazard. Pre-2008, traders could take a lot of risks for a chance at an outsized payout. If it worked, the trader would be compensated heavily. If the trade failed, the trader would be fired. However, the downside risk was minimal as the trader could simply get employed at another firm. With the possibility of an outsized payout and minimal downside risk, incentives were highly asymmetric. Thus, to mitigate the problem of moral hazard, clawbacks were proposed by the SEC. However, I believe that the Commission is going too far as its current proposal would extend to all publicly-traded companies , instead of just financial institutions. Essentially, the new proposal would obligate public companies to recover incentive-based compensation from executives for up to three years if they ever have to restate their earnings. Due to the all-encompassing nature of the provision, I believe that this topic should be of great interest to investors who invest in corporate America (NYSEARCA: SPY ) – in other words, nearly every investor out there. The proposal is deceptively simple. Despite its simplicity, I believe that there are severe ramifications that may materialize if it is passed. These ramifications primarily revolve around the misalignment of interests between shareholders and management . In his piece, Mr. Sorkin explained briefly how base/incentive compensation may be affected. Due to his brevity, I believe that readers may not have grasped the essence of his article. Therefore, I will expand upon the points he made. Before I do that, I believe that some context is required. A brief history of compensation Historically, employers compensated employees with a fixed base salary that grows by a small amount (usually somewhat correlated with inflation) every year. However, employers soon realized that this model was not sufficient to motivate their employees. As they were being paid a fixed base salary, employees were not incentivized to strive for performance – they were happy to complete the minimum required of them. After all, there was no need to outperform; there were no financial rewards for outperformance. Lip service might be given as a courtesy, but we all know what that is worth. In a bid to motivate outperformance, employers soon started offering bonus compensation to employees that exceed what was required of them. This bonus compensation can come in many forms – restricted stock, stock options, etc. However, they all have one thing in common. They were tied to performance. Some may be tied to sales targets, others may be tied to profit targets. This compensation model worked well for a while. However, employees soon found that it was a better idea to take stratospheric levels of risk for a probability at an immense financial payout. This produced the rogue traders that I believe that many readers are familiar with (London Whale, Nick Leeson, etc). The new SEC proposal The Commission’s new proposal is intended to mitigate the problem of moral hazard that comes with the asymmetric compensation model discussed above. The idea is rather simple – an employee that takes projects with unusually high amounts of risk may manage to achieve success in the short-term, but in the long-term the proposition is likely to blow up. Said another way, profits in the short-term might be outsized, but may need to be restated in the future (after being marked-to-market, for example). Thus, the employee would be compensated on the basis of the restated profits (which are typically much lower). In theory, it seems like it would work out. However, the situation is likely to manifest very differently in practice. Faced with reduced bonus compensation, executives are likely to take one of two routes: increase base compensation substantially to offset the decrease in bonus compensation, or increase bonus compensation to such a height that would ensure bonus compensation remain at pre-proposal levels post-proposal. Both routes are equally dismal for shareholders of corporate America. Suppose base compensation was increased in order to offset the decrease in bonus compensation. In this case, the situation would simply revert back to what it was historically – where employees were compensated with a salary that was largely fixed. Incentives for outperformance would be minimal. Thus, management would not be motivated to strive for performance. It is likely that management would simply be concerned with keeping their jobs, thus reducing the likelihood of them taking on large projects that would allow their company to grow. After all, there is no incentive to. As a result, shareholders of corporate America like you and me would be paying more for management that is content with maintaining the status quo. Growth realized by the S&P 500 has been sluggish in recent years, and the new proposal would exacerbate the problem. Alternatively, suppose that bonus compensation was increased to such a height that would ensure bonus compensation remains at pre-proposal levels post-proposal. In this situation, the net effect on bonus compensation would be minimal. However, as this scenario implicitly requires bonus compensation to be tied to a larger percentage of performance, the incentive to take on extremely high-risk projects would be heightened even further. In a nutshell, the problem of moral hazard would be amplified. Shareholders would be footing the bill once again. Expect this to contribute to a repeat of the 2008 crisis. In addition to the above, I believe that there other ramifications to consider as well. Other possible consequences Due to the fact that restatements of earnings tend to be as a result of an honest accounting error for the most part, corporate America as a whole is likely to hire more compliance personnel in a bid to minimize the possibility of error. Although compliance personnel play an important role, they do not generate any revenue or profit for the company. They are a necessary cost, but a cost nonetheless. For particularly large organizations, the increase in hiring of compliance personnel is likely to be substantial, which will materially reduce their bottom line. Once again, shareholders end up picking the tab. Recent regulation that called for banks to hold more capital (per Basel standards) have greatly reduced market liquidity . I opine that if this new SEC proposal was passed, liquidity would decline even further. It is no secret that financial institutions such as Citigroup (NYSE: C ), Goldman Sachs (NYSE: GS ) and Bank of America (NYSE: BAC ) are market-makers. Market-makers provide liquidity to the markets. They stand by willing to sell or purchase securities to and from willing market participants. Without a doubt, their role is a vital one. Recall that the new SEC proposal allows bonus compensation to be recovered in the event of a restatement of earnings. Mark-to-market gain/losses are one example of one such event. As bonus compensation is typically far greater than base compensation, executives of financial institutions are likely to cut back their presence in market-making in order to reduce the probability of the firm suffering from huge mark-to-market losses. Due to increased illiquidity, investors should expect increased volatility if the proposal is passed. Conclusion The new proposal proposed by the SEC aims to rein in outsized compensation. Despite its well-intended nature, the proposal is likely to result in widespread ramifications across corporate America if it is passed. No matter how you slice it, a misalignment of interests between shareholders and management are sure to occur. Increased compliance costs should follow as well. When all is said and then, public shareholders would be the one footing the bill. Additionally, the proposal could also result in a further diminishing in market liquidity, which would increase illiquidity. Although the proposal has not been passed yet, I believe that there is a high likelihood that it would be. The general public has always been inundated and resentful towards executives who command high levels of compensation. A proposal that aims to reduce compensation levels would likely be very popular. However, such proposals may have unintended consequences as detailed above. As these consequences are far-reaching, I believe that every investor should take note of the situation and perhaps consider investing abroad where public companies are not subject to SEC regulation. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Greece Bailout Agreement Adds To GLD Selling Pressure

Summary Greece had finally yielded to Creditor’s demand for austerity against the wishes of its people and this removes the Grexit risk. Fed is now more likely to rise rates as global growth is now more secured to get against financial stability as advocated by the BIS. Gold prices will continue to slump as a result. Greek Bailout Agreement This article is motivated by the breaking news that Greece had reached an agreement with its creditors after a 17 hour marathon negotiation session. It was a make or break moment for Greece and Greece folded to the EU austerity demands despite a clear ‘No’ referendum result on July 5. As the screen shot from European Council President Donald Tusk’s Twitter account shows, there was unanimous approval for the third Greek bailout. Source : Twitter In the end, pensions will be cut and taxes will rise for Greece to stay within the Eurozone and pay its debt on time. Austerity will continue to bite against of the Greek population wishes but at least we can see the light at the end of the tunnel. It is possible that Greek banks will open by the end of the month as the European Central Bank (ECB) is likely to increase its funding support and deposit flight would be reduced greatly. Implication For Gold Prices However the key question for this article would be what does it mean for the price of gold? My previous position for the price of gold is that the premium for USD in the rush for safety will outweigh the premium for gold over Grexit financial stability concerns. This has largely played out which I would highlight in the gold price chart towards the end of the article. Today we have a different situation where the threat of Grexit has largely been taken off the table. This would be even more bearish for the price of gold. The obvious point is that there will be less concern over financial stability. Hence there is now less need for the financial markets to hold gold. The second and less obvious pull factor away from gold would be that it would clear the path for the Fed to rise rates earlier. This could now be done as early as the FOMC meeting on 17 September 2015. We can have more clues from the July 29 FOMC statement and the minutes which will be published on August 19. It is clear that the US economy had been consistent progress especially in the second quarter of 2015. The Fed is approaching its mandate of maximum employment with unemployment at 5.3% and the target unemployment range is from 5.0% to 5.2%. This range has been revised lower consistently and wages have gone up as a result. Quit rates have gone up as well as employees quit jobs to find jobs that fits them better. This is a result of higher confidence in the jobs market which translated to better consumer confidence. The Fed is confident of hitting its 2% inflation target in the medium term over the next 2 years and this period would be the time for them to raise rates and get ahead of the curve. BIS Support For Rate Hike & Growth Implication On the international front, there has been difference in opinion between the Bank of International Settlements (BIS) and the International Monetary Fund (IMF). The BIS advocated that the Fed rise rates as soon as possible so as not to punish savers unnecessarily and to create bubbles in other parts of the financial markets. In addition, the higher rates would also give the Fed the tools it need to deal with the next crisis. This is the quote for the relevant Handelsblatt interview which the BIS expressed its views Do you think that central banks should raise the interest rate earlier and faster in order to preserve financial stability? Would that be your advice for the Fed? Mr. Caruana: We think there are risks and costs if central banks raise interest rates too late. They become apparent only once you fully factor financial stability considerations into monetary policy. But at present the debate is not paying much attention to this. Rather, it focuses on the costs of raising interest rates too early. Mr Jamie Caruana is the General Manager of the BIS. This article was published recently on July 10 and it is in response to the IMF opinion that the Fed should push its rate hike to year 2016. IMF Managing Director Christine Lagarde advocated that the Fed push its rate hike to year 2016 so as not to undermine the fragile recovery. Conclusion The Greek bailout agreement takes the risk away that a rate hike would hurt the European recovery as a whole. This would also mean that higher growth would also necessitate higher interest rates to tame inflation going forward. If institutional savers are constrained by artificial low interest rates, they would be tempted to push up other asset values such as real estate or the equity market. This is the financial stability risk which the BIS was referring to. It is not saying that the Greek bailout would lessen financial stability risk and hence there is lesser need for a rate hike. (click to enlarge) As we can see from the SPDR Gold Trust ETF (NYSEARCA: GLD ) chart above, gold prices have been bearish for the past month as the Grexit crisis intensified as predicted by my previous articles. This is likely to continue in the near future as the chances of a Fed rate hike in September 2015 goes up. Hence we should continue to avoid gold in the short run. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.