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Lesson 7: A Two-Horse 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?

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.

 

Bruce Gould

 

Always remember that stock, options, and futures trading may involve substantial risks and that past performance is no guarantee of future performance.