What is Your Edge in the Market?

May 15, 2013

in Investing

By Alvin Chow (guest contributor)

How do casinos, insurance companies, lottery operators, and market makers consistently make a lot of money?  The answer is simple: Edge.

Many Singaporeans love to buy 4D and go to the casinos. They are lured by the big profits that could be made by risking a small amount of money. The risk-reward ratio of a first prize in 4D is 1:2000. It definitely looks profitable to risk $1 in order to make $2,000.

What is your probability of winning?

But what is the probability of winning? For simplicity, let us only consider the first prize in our calculations. The probability to win first prize would be 1/10000 and the probability of losing becomes 9999/10000.

Now, here is the secret why Singapore Pools make money – expected probability. The expected probability of you making money = (1/10000 x $2000) – (9999/10000 x $1) = -$0.7999

This means that for every $1 you bet, you tend to lose $0.80. It may look small, but over the long run your wealth will slowly bleed away. Singapore Pools is happy to risk $2000 to make your $1, because they know they will make $0.80 in steady state. The more frequent and the higher amount you bet, the more they earn.

The house always has the edge

In casinos, the playing rules and payouts are always calculated such that the house has an edge. It does not need a big edge. Just a $0.01 advantage can make tons of money. This is because they have a large number of opportunities to exercise their edge. The faster the opportunities arise, the more money is made.

Insurance companies, for the same reason, hire bright mathematicians, statisticians and actuarial science graduates to underwrite policies for them. Premiums are calculated in such a way that they will make money from a pool of clients that is seeking to offset risk.  It is a win-win situation for the client and the company. The company earns profits, and the client gets covered financially.

Recently, there have been a proliferation of brokers who are market makers. What made them so aggressive to attract clients with their advertisements? These market makers usually take the opposite side of the client’s trade. In other words, the brokers earn what the clients lost and vice versa. They are keen to give you leverage and encourage you to trade more by offering low commissions. Most people lose money in the markets, and that is the edge that the market makers have—by taking the opposite side.

What is your edge that will give you profits over the long run? If there’s no edge, you might as well be buying 4D with a negative expectancy.

First, your edge comes in the form of knowledge or skills you possess, which you apply to the market that yields a positive expectancy. Second, you must have sufficient opportunities to apply your edge in the market. You will then make money faster with more opportunities.

 

By guest contributor Alvin Chow, who blogs at Big Fat Purse, a Singapore personal finance blog.

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