One of the things that I often hear from the public, family and friends is that participating in the stock market is like gambling. You have no way of knowing whether it’s going to go up or down or sideways. You place your bets and hope you’re right. If not? Oh well you lose money. That’s gambling and that’s the deal when you sign up. But none of this should be true. The stock market is NOT meant for gamblers.
When I look at markets (and we’ll expand to all markets, not just stocks), what we search for is a risk vs reward opportunity that meets our time frame, risk parameters and objectives. We’re all different and we have different answers for all three of these. But to me, if the risk is $1 for every $5 of potential reward, the trade is skewed in my favor. I can be wrong 80% of the time and still not lose any money. And more often than not, the risk/reward opportunities I look for go beyond 5:1 and lean closer to 8:1 or 10:1 in an ideal situation.
When you gamble, let’s say on the Super Bowl, what are you really doing? You’re picking a team and hoping they win. If you’re wrong you lose it all, if you’re right you double your money (which is actually less if you include the vig). So you’re looking at less than a 1:1 risk vs reward. That’s a coin flip that can go either way. This is gambling.
When you see a chart trading right in the middle of a huge range, once again your risk reward is 1:1. That’s not in your favor. This is gambling.
There is a huge difference between using the market and focusing your attention on risk management and just throwing money at the market and hoping for the best. “Hey I heard these marijuana stocks are doing great, I should buy some”. You have no idea how high they can go and you have no idea at what point you say you’re wrong and get out. Without a plan it’s called gambling.
If you see a major reversal day and a stock makes a new high and then rolls over hard, you can short it. You’re wrong if the stock makes a new high taking out your stop loss – and you know this going into the trade. Figure out percentage-wise how much that is and then see if your price target is far enough away that it presents a risk/reward favorable enough to enter. Does it meet your risk parameters? Does it fit your time horizon? Does it match up with your overall market objectives? Yes, yes and yes? Go for it. If it doesn’t, then at least you know and you stay away. This is called risk management, not gambling.
There is a major difference between the two. The market can be a gamblers paradise. But that’s not what we are here to do. Our #1 priority is always defense and risk management. $TSLA is a good example of one that I never traded on the long side. Why? I could not define the risk. If I can’t answer the question of, “how much risk am I taking in this name?”, I will not enter it. I’d rather miss out on the upside than risk more than I’m comfortable with to the downside. Sure it may be frustrating at times when you see a name you like go up without you. But that’s the business. That’s the downside of staying disciplined, defining your risk tolerance and objectives.
On the other hand, if you do your homework you will always be able to find risk/rewards that are skewed in your favor. I myself take pride in looking at stock markets from all over the world, not just the Dow Jones Industrial Average. More importantly, we take our analysis across asset classes and position ourselves in fixed income, commodities and currencies when the opportunities present themselves. And if you look at enough markets, trust me you’ll find plenty to suit your needs.
So when somebody tells you that the stock market is gambling, wink at them at tell them that it can be. It happens to be a giant casino for far too many people. But if you manage risk correctly and stay true to your goals and risk tolerance, there is no gambling involved. This is a risk manager’s paradise.