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There Is No Free Lunch

By Kerry Given

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Published: 04Aug2009
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This time honored saying was one of my father's favorites. It has broad applicability, but it rings especially true for stock and options trading. For example, I recently read the following on the web site of a well known options trading education firm:

"When was the last time you made 300% in three weeks?"

And during a recent webinar by a stock and options trading education and advisory firm, the speaker was discussing his background and experience and explained that he had: "discovered the Holy Grail of Trading."

There is a tendency, seemingly inherent in humans, to believe that someone out there has the secret formula or inside track to making money in stocks and options trading. Of course, that simply isn't true. There is no free lunch.

One of the most fundamental laws of finance links risk and reward: high rewards only come at the expense of incurring high risk, and, conversely, low risk investments necessarily result in low returns. There are many different ways of trading stocks and options. But these different strategies can each be characterized by a risk/reward ratio. Trades with high risk/reward ratios offer high probabilities of low returns, but those consistent, low returns are accompanied by very large potential losses, albeit with low probabilities of occurrence.

On the opposite end of the spectrum, one has low risk/reward trades where the losses are small but highly probable - these are the "lottery tickets" of stock and options trading. The potential gains are huge (as in "300% in three weeks"), but the probability of achieving that gain is very small. Consider the classic covered call strategy as an example. If we choose to sell the At The Money (ATM) call this month, we have approximately 50:50 probabilities of the stock being called away or the call expiring worthless. In either case, we will make our 2-3% in less than a month and be happy with our trade. However, if the whole market tanks and our stock is taken with it, the income from the calls we sold will only compensate for a portion of our loss - there is no free lunch.

Now this isn't meant to suggest that all trading strategies are destined to fail. That obviously can't be true - there are too many well documented success stories. However, we should always become a bit skeptical when we hear or read a promotion that the XYZ trading system has returned 54% every year for the past ten years and can be expected to continue to perform at that level into the future.

Successfully trading any market requires education, hard work, a systematic approach, practice (experience), and discipline. There is no free lunch.

Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years of experience investing in the stock market and over seven years experience trading equity and index options. He has taken many classes on investing and trading through the years and has discovered first hand how difficult it can be to separate the financial facts from the marketing hype, myths, and get rich quick schemes. He can be reached at: www.ParkwoodCapitalLLC.com

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