An excellent understanding of probability is essential for effective risk management. We hope this article is a useful supplement to the concepts we introduced in "Coining Some Terms." In this article, instead of a coin, we will use a six-sided die.

One of the most critical tools for risk management originating from probability theory is fair value. We can use fair value to understand, and therefore harness a range of uncertain future outcomes. In the case of a six-sided die, let's assume we want to know the fair value of a bet that pays one dollar for every spot shown on the dice after a single roll. The proper way to calculate that fair value is to multiply each outcome's value by its probability. Which looks like this:

(1/6*1)+(1/6*2)+(1/6*3)+(1/6*4)+(1/6*5)+(1/6*6) = 3.5

If all outcomes are equally probable (as they are in this example), there is an easy shortcut. We can total the value of all outcomes and divide by the number of outcomes, like this:

(1+2+3+4+5+6)/6 = 3.5

I have always found it interesting that a fair value can be, and often is, not a potential outcome (there is no 3.5 on a standard six-sided die). We touched on this concept in an earlier article entitled "Risk Premiums."

By understanding the fair value of a bet, we can determine if it has an edge (A concept we introduced in "The Relationship Between Risk, Reward, Edge, and Risk Management"). For instance, if we could pay $3.00 to roll the dice once and receive $1.00 for each spot, we would have $0.50 of edge. We would also have a max loss of $2 and a max win of $3. These conditions make for an excellent bet. That might not seem very exciting - that part is still to come.

It might seem like we are a long way from the farm, but we are closer than you think. If we multiply the above bet by $100,000, the edge becomes $50,000, with a max loss of $200,000 and a max win of $300,000. That sounds a lot more like farming, and hopefully, I've still got your attention because here comes the exciting part.

If instead of multiplying the stakes by $100,000, we decide to make the smaller $1.00 bet 100,000 times, things change drastically. The edge stays $50,000, only now it is much more likely to be realized. When we shift from a single large bet to many smaller ones, our advantage becomes much more real and much less variable. Effective risk management works similarly. Rather than making a massive bet with a highly-variable outcome, risk management can lessen the stakes while having a low impact on a producer’s overall edge.

At Quartzite Risk Management LLC, we want to help producers stay in the game for the long run. We are experts in working with producers to create and implement effective risk management strategies. If you're interested in learning more, contact us today or read more about Quartzite Precision Marketing.