Friday, December 04, 2009

I'm the Casino, Part I

No matter how hard I try to explain it, people will always say this about trading:

"It's just like gambling."

You're right; it IS like gambling. There's one thing those people are neglecting to understand:

I'm the casino.

We'll get to that a bit later. Right now, we've gotta get a few things out into the open.

So, people think of trading like gambling for one simple reason: You risk money on an unknown outcome and stand to either lose that money if your prediction is wrong or gain money if your prediction is right. After all, risking anything without knowing the outcome is gambling, pure and simple, right? Let me pose this comparison that should open your mind to trading as a legitimate business.

When people start a business, what do they do? They invest money into the business based on the belief that by investing the capital resources into that business, their capital will grow, though many businesses fail and those people lose that money. In many cases, they lose ALL their money because one cannot predict the future and the money risked is on an unknown outcome. Sound familiar? How is this not gambling? You risk money on an unknown outcome in the hopes of profiting on the risk you take. People don't like to call starting a business gambling, probably due to some long-standing social stigma that it's OK to risk capital when you setup a shop to hawk your wares or services, but trading is gambling because...well, I don't really get why people call it gambling. Maybe it's because they're uninformed and fear what they do not know. I'm guessing people see it as a risk/reward sort of thing and the speed at which gains/losses occur, as well. Not many local hamburger stands will earn a $1mm profit or lose everything in less than a year, yet you hear both those stories from the world of trading every day via whatever trading/investing site you choose to visit. I believe it's also because with trading you're risking capital each and every trade whereas starting a business is really just 1 big initial investment followed by additional capital invested into the business to maintain it. But I'd argue that trading is a safer bet because instead of going all in, you're simply paying a small ante each time and your bankroll grows slowly.

So, back to the casino. Why do casinos stay in business and how do they make money? They have what's called an "edge." This edge is the statistical advantage they have on every bet that is made on one of their games. Some bets like the pass-line on a craps table (which is my favorite table game) have a very small casino edge of around 1.4%. So, for every $100 bet, they are expecting to earn $1.40, per their calculated edge. Sticking with craps, some bets have an incredible house edge like an "any 7" bet, which has a house edge of 16.67%. Combine all of these different bets and you have the overall casino edge on ALL the games they operate.

So what does this have to do with trading? Well, each trader works on a certain trading strategy or system that gives them an edge, just like the casino. This edge is in effect the expectation of your system. For some traders, their edge is extremely high for others it's very low. For a great deal of traders, it's actually a negative expectation, whether they know it or not, which is why it's estimated that something like 95% of the traders lose. (not sure I totally agree with that #, but to some degree it is true...)

The key thing to understand about trading is this: there's an expectation of loss. There is no trading system with a 100% win rate and you're going to expect to take losses. However, there's an expectation of winning as well and although a system may expect to take losses, it should end up being net positive at the end of the day. This is very difficult to grasp for the human mind. Imagine if you were a musician and only played 75% of the notes properly? Or, that you were a lawyer and successfully litigated only 55% of the cases you brought to trial? You probably wouldn't last long yet there are trading systems that only need to be successful less than 50% of the time to be wildly profitable and successful. In that respect, trading is sort of like baseball. A career .400 hitter is getting a fast pass to Cooperstown, yet he only hit the ball 4/10 times on average.

Where I believe that trading (at least in the responsible, effective way I practice) differs from gambling is this. Gamblers are on the losing end of the stick before they even place a bet; there is a negative expectation. Therefore, an incredible amount of their success is built on luck. Sure, poker is a different beast because there is actual strategy and craps to a degree can be "gamed" as well with some great strategies that ensure you last at the table a very long time and fight the negative expectation. However, you're always still reliant on luck and must keep track of the wins/losses and remember the house edge. There's the element of "I'm due" in gambling, implying that the house is winning more right now than it statistically should and the tables are bound to turn your way soon. You ever hear the saying "this table is HOT"? Well, this is the human mind qualifying the current statistical climate of a game, which of course, is complete and utter nonsense. There is just as much chance you are going to throw a 7 whether the previous 100 rolls were 7's or anything but 7. Dice have no memory and do not react based on what happened earlier, plain and simple.

You gotta know when to hold 'em and when to fold 'em isn't just a great song lyric, but a very accurate description of the gamblers dilemma as their mind tries to figure out whether they are part of a statistical anomaly or just going with the flow. Effective trading, on the other hand, is very different. You're not reliant on luck or probabilistic forces that are out of your control. You control your destiny and to some degree dictate the destinies of others, much like a casino.

Part 2 coming up a bit later this afternoon...

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