What is the cost of being wrong? Everything you do in your life, trading or otherwise centers around this central tenet. You are wrong quite often in life, but usually the things you are wrong about do not carry dire consequences. For example, if you forget what time a movie was suppose to start. Or if you are wrong about the score of last night's football game. Or perhaps wrong about some trivial piece of information such as how high did the fed funds rate get in 2000. These things are of little importance in the big picture. Other things you do not want to be wrong about. For example, the babysitter you hire to watch over your children, having unprotected sex with the wrong person, underpaying your taxes, or perhaps even, the amount of inebriation while getting behind the wheel of a car. In these situations, being wrong carries substantially more risk. Well, in trading, you should always ask yourself, what is the cost of being wrong? Not what is the likelihood of being wrong. These are two different things. Let's say you have a trade on that says there is a 99% probability you will make a little bit of money every month. But a 1% probability that you lose everything to your name. Even though that 1% is very unlikely, the cost of being wrong is just too great.
Think of this. Would you put a gun to your head that had 99 empty chambers and one chamber with a bullet in it and pull the trigger? Of course not. Even though there is a 99% chance everything will be fine, that 1% will result in immediate death, therefore you don't do it. But for some psychological reason, we don't fear losing all our money to be the same as death, even though to some people the events are analogous. Do not trade in such a way that if the worst of luck happened to you. If Murphy's law went into effect. If the grim reaper should knock on my door, or the kiss of death should sit down beside you, you will not have the possibility of financial ruin. That doesn't mean you won't lose money, it's just that you won't have a strategy that offers you that possibility. Many people espouse their track records and their experience and how many years of profitability they have had only because their dark day is still ahead of them. Because they have not seen it yet, they believe it doesn't exist.
To use a funny example, take life. A 32 year old man has lived 11,680 successful days without dying. He must be immortal as he had not died once yet during those 11,680 days therefore I doubt he will ever die. This is a common fallacy of course. Our mind is built to use past experience, not true probability when it comes to making decisions. In the 1980's it was the disbelief that AIDS existed. Hey, if you never got it, why would you believe you ever would?
The thing is, the only way to get around this barrier in our mind is to force ourselves not to look at past experience, but rather future possibilities. If you had to make the same trade 1000 times under 1000 different lives, how many times would that decision produce a positive outcome or a negative outcome. Under many situations, what happened to LTCM in 1998 would not have happened under some of their alternative lives, a few of them would have lead LTCM to be the most successful fund ever. Same thing about naked options selling. One has to ask themselves is it really worth the risk to take in such small amounts of money to have the goddess of risk pay you a visit? Do you really want to tempt fate that much? There are always two paths in every forest. There is always an easier path that everyone would be inclined to choose. It carried a lot of hidden risks, but most people would get through OK. The rewards were often less than satisfactory on this path. Then there is the other path. The other path was always darker, harder, more challenging and many did not make it through. But the rewards were substantial, not always from a monetary standpoint, but from a personal standpoint of taking the road less travelled. Selling naked puts might be easy and produce years of gains, but anyone can do it. The risks to some are huge and quite devastating. Everything in life has risk. Flying, driving, eating bad fish. The difference is, those are things we have to do. We don't have to sell naked premium. Why go through the motions of putting a loaded gun to your head when you don't have to?