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Asymmetric Reward to Risk: The Holy Grail of Investing
Asymmetric reward to risk is a concept in investing that explains a situation where the potential gains from an investment are far greater than the potential losses. In other words, the risk of taking a slight loss is worth the potential substantial profits. Finding asymmetric reward to risk scenarios in the stock market is the holy grail – but it is not easy, requires risk management measures, counterintuitive thinking, and is not for the emotionally unstable.
Most of Wall Street’s legendary investors have made their fortunes through asymmetric bets, not winning percentages on trades. For example, billionaire fund manager Paul Tudor Jones proclaimed in an interview that he shoots for a reward-to-risk ratio of 5 to 1. For every dollar he risks, he aims to make five. By shooting for significant gains (running his winners and cutting his losers), Jones only needs a 20% hit rate to break even.
Real-Life Examples
In 2009, David Tepper bought a swath of distressed financial stocks such as Bank of America (BAC - Free Report) through his fund Appaloosa Management.
Image Source: Zacks Investment Research
While no one wanted to touch financial stocks in the immediate aftermath of the Global Financial Crisis, Tepper correctly predicted that the U.S. government would not allow the U.S. banks to fail and would provide stimulus. By the end of the year, Tepper was able to parlay the 2008 crisis into his opportunity – netting Appaloosa Management a cool $7 billion, of which $4 billion went into his coffers.
Another example would be angel investing. Investing in start-ups is far from an exact science. In fact, most start-ups ultimately fail. However, occasionally angel investors stumble upon the next Uber Technologies (UBER - Free Report) or Alphabet (GOOGL - Free Report) . Again, what’s essential in this method of investing is not necessarily having a high percentage of correct investments, but rather profiting handsomely from a small percentage that ultimately makes up for the losses and fuel performance.
Natural Gas: A Potential Asymmetric Opportunity
Natural Gas prices are approaching all-time lows as production is nearing highs and demand stays near the average. However, this can change on a dime as China’s economy emerges from strict lockdowns, and demand is expected to increase dramatically. Furthermore, European gas reserves will need to be replenished soon. While Natural Gas is a very volatile commodity to trade, investors in search of a potential asymmetric bet may want to give it a look because it has the following:
Defined Risk: A large price reversal on Wednesday gives investors a “line in the sand” area to trade against. The United States Natural Gas ETF (UNG - Free Report) reversed early losses to finish up 5.13%. Investors can implement a stop-loss or loss-cutting area at 10% or so or measure below Wednesday’s low to ensure that risk is defined.
Considerable Reversion to the Mean Potential: UNG’s 50-day moving average is some 35% higher than the current price. Investors can risk ~ $1 (distance to recent lows) to make $5 (distance to 50-day MA).
Image Source: Zacks Investment Research
Extremes: UNG is showing signs of downside exhaustion. First, the Relative Strength Index (RSI) shows extreme oversold levels. Second, volume is reaching unprecedented levels over the past few weeks – a potential capitulation sign.
Image Source: Zacks Investment Research
Conclusion
Most successful investors you hear about generate returns through a few large winners (and a lot of smaller losers). In baseball terms, investors should aim for a higher “slugging %” rather than a high batting average. By having a high reward-to-risk ratio, like 5 to 1, investors can eliminate the need to be perfect or even right more than 50% of the time. Natural Gas is one attractive potential asymmetric opportunity developing. Because it is trading at extreme levels and has a defined reward-to-risk ratio, investors may want to give it a shot. If Natural Gas is to bounce, sister plays like the Proshares Ultra Natural Gas ETF (BOIL - Free Report) and Tellurian (TELL - Free Report) stand to benefit.
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Asymmetric Bets: The Holy Grail of Investing
Asymmetric Reward to Risk: The Holy Grail of Investing
Asymmetric reward to risk is a concept in investing that explains a situation where the potential gains from an investment are far greater than the potential losses. In other words, the risk of taking a slight loss is worth the potential substantial profits. Finding asymmetric reward to risk scenarios in the stock market is the holy grail – but it is not easy, requires risk management measures, counterintuitive thinking, and is not for the emotionally unstable.
Most of Wall Street’s legendary investors have made their fortunes through asymmetric bets, not winning percentages on trades. For example, billionaire fund manager Paul Tudor Jones proclaimed in an interview that he shoots for a reward-to-risk ratio of 5 to 1. For every dollar he risks, he aims to make five. By shooting for significant gains (running his winners and cutting his losers), Jones only needs a 20% hit rate to break even.
Real-Life Examples
In 2009, David Tepper bought a swath of distressed financial stocks such as Bank of America (BAC - Free Report) through his fund Appaloosa Management.
Image Source: Zacks Investment Research
While no one wanted to touch financial stocks in the immediate aftermath of the Global Financial Crisis, Tepper correctly predicted that the U.S. government would not allow the U.S. banks to fail and would provide stimulus. By the end of the year, Tepper was able to parlay the 2008 crisis into his opportunity – netting Appaloosa Management a cool $7 billion, of which $4 billion went into his coffers.
Another example would be angel investing. Investing in start-ups is far from an exact science. In fact, most start-ups ultimately fail. However, occasionally angel investors stumble upon the next Uber Technologies (UBER - Free Report) or Alphabet (GOOGL - Free Report) . Again, what’s essential in this method of investing is not necessarily having a high percentage of correct investments, but rather profiting handsomely from a small percentage that ultimately makes up for the losses and fuel performance.
Natural Gas: A Potential Asymmetric Opportunity
Natural Gas prices are approaching all-time lows as production is nearing highs and demand stays near the average. However, this can change on a dime as China’s economy emerges from strict lockdowns, and demand is expected to increase dramatically. Furthermore, European gas reserves will need to be replenished soon. While Natural Gas is a very volatile commodity to trade, investors in search of a potential asymmetric bet may want to give it a look because it has the following:
Defined Risk: A large price reversal on Wednesday gives investors a “line in the sand” area to trade against. The United States Natural Gas ETF (UNG - Free Report) reversed early losses to finish up 5.13%. Investors can implement a stop-loss or loss-cutting area at 10% or so or measure below Wednesday’s low to ensure that risk is defined.
Considerable Reversion to the Mean Potential: UNG’s 50-day moving average is some 35% higher than the current price. Investors can risk ~ $1 (distance to recent lows) to make $5 (distance to 50-day MA).
Image Source: Zacks Investment Research
Extremes: UNG is showing signs of downside exhaustion. First, the Relative Strength Index (RSI) shows extreme oversold levels. Second, volume is reaching unprecedented levels over the past few weeks – a potential capitulation sign.
Image Source: Zacks Investment Research
Conclusion
Most successful investors you hear about generate returns through a few large winners (and a lot of smaller losers). In baseball terms, investors should aim for a higher “slugging %” rather than a high batting average. By having a high reward-to-risk ratio, like 5 to 1, investors can eliminate the need to be perfect or even right more than 50% of the time. Natural Gas is one attractive potential asymmetric opportunity developing. Because it is trading at extreme levels and has a defined reward-to-risk ratio, investors may want to give it a shot. If Natural Gas is to bounce, sister plays like the Proshares Ultra Natural Gas ETF (BOIL - Free Report) and Tellurian (TELL - Free Report) stand to benefit.