When does gambling reduce risk?

Question

Suppose that you face risk. It is obvious that taking gambles whose outcomes are negatively correlated with the outcomes of your other gambles can reduce your overall risk ('hedging'). My question, however, concerns **uncorrelated** gambles - can these reduce your overall risk, and if so when?**Edit**: to be clear, I am asking about when you can reducing your risk by taking **additional** uncorrelated gambles, not simply by replacing some gambles in your portfolio with others.

Answer 1

Hey there,

While I wouldn't consider it directly "gambling", options trading is a great way of hedging risk, and may parlay well into your question.

Take for example a put option. A put option gives you the right to sell a stock at a contracted price if the stock price falls below a certain price (the strike price).

Let's say you buy a share of stock at $50. You're hoping it does well. But, to hedge that risk, you buy a put option, with a strike price of $45 in case the stock doesn't do well.

If the stock falls below $45, you have the contractual right to sell it at $45, even if the market value of the stock is well below that.

That said, the main risk with this strategy is, if the price doesn't fall below the strike price, you're out on the money you used for the option premium. Then again, if you bought the stock with the intention of it appreciating in value, you're probably not all upset about that.

I hope this gives you some perspective on your question.

-Jose