Lesson 7: A Two-Horse Race
There are two horses in a race. They are equal. Neither is favored to
win the race. You have no idea which horse will cross the finish line
first as you know nothing about either of them. You want to bet on
horse (A) or horse (B). Just as you are about to decide, you are told
that whichever horse you bet on, it can never be 10 feet behind the
other horse once you have placed your bet, or you will lose your
money. This is true even if the horse you select eventually wins the
race. You are, however, allowed to place your bet at any time during
the race up to the last fifty feet. You decide to bet on horse (A)
and right out of the gate it falls 15 feet behind horse (B).
Eventually your horse (A) wins the race by three lengths but you have
lost your money. The furthest that horse (A) was ever behind horse
(B) was the 15 feet at the start of the race.
You know that horses often fall behind at the start of a race and
then catch up as the race continues. Is there any way you could have
placed your bet so that you would have won the wager? Of course there
is. You could have waited until your horse was 10 feet behind and
then bet that horse (A) would never be 20 feet behind. Remember you
are allowed to place your bet at any time. Why not wait until your
horse is 10 feet back and then place your bet. There is one reason
why not. Your horse may never be 10 feet back and thus the
opportunity to bet on horse (A) may never arise. But is this a good
reason? There will be another race shortly. If you miss betting on
the first horse race of the day, then bet on the second. You know
that this method of waiting to place your bet works best when the
horses are of equal abilities and there are only two horses running
in the race.
Gold futures are selling at $300.00 an ounce. You are not sure
whether gold will advance or decline. You believe there is a 50/50
chance that either will happen. Should you go long gold and buy
futures contracts or options or should you go short gold and sell
futures contracts or options? You have no idea. To you it is a two
horse race. (A) prices may advance or (B) prices may decline. Which
should you pick? Should you bet on horse (A) or horse (B)? One thing
you do know. You are willing to risk no more than $20 an ounce
whichever way you bet. If you buy gold futures long at $300 then you
plan to place a sell stop/loss order at $280. If you sell gold
futures short at $300 then you plan to place a buy stop/loss order at
$320. Unable to make a decision you flip a coin, heads you go long
and tails you go short. It comes up tails and you decide to sell gold
futures short at $300 an ounce. You lay out a plan to enter your
orders so that if gold rises to $320 your stop/loss is hit and you
are out for a loss. If gold declines to $280 you will buy back your
short position for a profit. You feel it is certain that gold will do
one or the other and a 50/50 probability that it will do either
first. You are now in a two horse race and you have selected horse (B).
But then you start to think that with your luck the market will
probably rise by $20 before it declines by $20. In simple terms, your
horse (B) will probably be 20 feet behind your entry price before it
declines to $280 and wins the race. What can you do? You decide to
learn a little from the horse race example at the start of this
lesson. In futures, stocks, or options, you are allowed to enter the
market at any time before the end of the race. Think of gold as
racing toward $280 an ounce and $320 an ounce. You win if it first
hits $280 and you lose if it first hits $320. You feel there is a
50/50 chance of either event happening.
If there is a 50/50 chance of gold hitting $320 before it hits $280
or vice versa, what happens if you raise the $320 to $340? If gold is
$300, would you think the odds are equal that it will rise to $340
(rise $40) before it declines to $280 (decline $20)? What are the
odds that a market will move $40 in one direction before it moves $20
the other? Assuming that markets are efficient and that current price
is always the best price, the odds should be equal that markets will
move an equal amount in either direction but not equal that markets
will move $40 one way before moving $20 the other.
You are willing to lose $20 an ounce betting on gold. You don't want
to lose $20, but you are willing to lose it. You want to sell a
futures contract short and you are willing to sell it on the 50/50
probability that you will make a profit before you suffer a loss.
What about delaying your entry until the price has reached your stop/loss
order level and then taking your short position? In other words, if
you are betting on horse (B) and that it will never be 20 feet behind
horse (A) by delaying your bet until your horse is actually 20 feet
behind you are giving yourself 40 feet of slack before your bet is
lost instead of 20.
Think about crude oil for a while. In Lesson Number 3 we were
wondering whether crude oil, then priced at $25 a barrel, would rise
to $30 or decline to $20 first. We now know the answer, at least for
the year 2000. Crude oil rose to $30. In fact, it rose above $30. If
you shorted crude oil at $25 and bet that your horse would never be
$5 behind, you are out of the market. Horse (B) did fall $5 behind
when prices rose to $30 and all the shorts who had stop/loss orders
at $30 were taken out of the market at that level or thereabouts. In
hindsight, 20/20 vision, what if you had said that you wanted to bet
that crude oil prices would decline, but that you did not wish to
place your bet until the original stop/loss price had been hit. In
other words, you would wait until your horse was $5 behind before you
would bet that it would not be $5 behind. In essence, you would be
betting that your horse would not be $10 behind in the race. We now
know what happened to crude oil since it was priced at $25 a barrel.
We do not yet know what will happen to gold when it is currently
priced at $300 an ounce. But whatever does happen to gold prices,
isn't it worth considering as a possibility that you might delay your
short entry until your original stop/loss price would have been hit
had you placed a stop/loss at that level? You can still take the same
side of the market, but you do not enter until your originally
planned (but not actually entered) stop/loss order has been hit. Is
this something you might consider?
Mr. Jones speaking to Mrs. Smith. "I am generally right in
picking market direction, but my stop/loss always seems to get hit
before the market runs in my favor". Mrs. Smith to Mr.
Jones. "Why don't you pretend to put your buy or sell order
and your stop/loss order in but not really put either of them in.
When the pretended stop/loss level is reached, then and only then
enter the market with a new stop/loss the same distance from your new
entry price, as your original stop/loss would have been. If you are
right, that you are generally able to pick market direction, but keep
getting stopped out with your initial stop/loss order, this should
help solve your problem". Mr. Jones to Mrs. Smith. "Why
didn't I think of that"?
Suppose you want to go long (A) a market or short (B) a market and
your number one problem is that when you are long, your sell stop is
always hit before the market turns up and when you are short, your
buy stop is always hit before the market turns down. If this is your
problem maybe you should consider entering the market at your
stop/loss points rather than at your original entry points? This idea
may be one you might want to think about and discuss with your
partner. I will have something more to say about it shortly.
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