Trading and Poker

FYI: This is an update to an article I had published in November 2006 in The Trader’s Journal: How the Poker craze can Help you Trade

I have been trading my own accounts for a decade now and I continue to learn more with each passing day. However, I never thought that a game, a hobby of mine, would advance my understanding and the importance of expectancy and position sizing as much as playing poker. Trading the markets and playing poker both require strict money management rules, stable emotional balance and a solid game plan. If you don’t consider and employ these tools, you will most likely fail sooner rather than later and lose a lot of money along the way.

So, how could a person learn so much from a game that most people consider luck? And why do some traders continually profit year after year while others lose their shirt while making the same mistakes? I will discus the basics of position sizing and expectancy and show you how both items are extremely important when trading and playing poker for profits. I will also close the gap of how each entity (trading and poker) have helped me become better at both.

Many people consider trading and poker pure luck but this is not an accurate observation. Average traders and average poker players taint the outside world with images of luck, quick riches and pure fantasy of the actual grind that is required to succeed. Many factors run parallel with poker and trading but the average Joe would never understand ‘why’ because he or she just listens to what the “talking heads” of television say. Luck may and will play a small part under certain circumstances but rules, odds, risk and money management are the largest components of the two entities.

It’s a grind; trading for a living and playing poker for a living is a grind – a full time business.

I don’t trade for a living but I do trade/ invest to grow my personal wealth. The savings and income from my main career is put to work through investing.

When investing in the stock market, it is essential to have a sound set of rules or a system that has been tested in real time, (back testing or historical testing is not required but can be used, my opinion of course). Back testing helps but playing sports has taught me that Monday morning quarterbacking is for theorists. Once a system has been tested profitably in real-time, the trader or poker player must follow clearly defined rules in order to preserve capital and cut losses. Both traders and poker players must consider the odds of their stock or hand making a gain or making a loss. Price objectives and targets should be a large part of every investor’s system but it is not the essential ingredient to success. Understanding how much to trade or how much to bet and exactly when to make that bet will be based on the system’s expectancy – and this should be the top priority.

So where does system development start? It starts by properly understanding position sizing techniques and calculated expectancies. Using these tools, the investor will be armed to trade only in situations where the odds are in his/her favor. A system that has been tested will have an approximate expectancy that will tell the trader or poker player how much will be gained or lost during each trade or hand over a period of time. Using this as one part of the equation, the investor or trader will now determine how much risk to undertake by calculating a position sizing algorithm that tells them how much to place on a specific trade or poker hand. The word “algorithm” may scare many people away but I have developed very simple position sizing and expectancy spreadsheets that can be found as a link on my blog. They can be downloaded, studied and tweaked without any advanced mathematical experience. This spreadsheet is strictly for trading, not poker.

Most traders and poker players look for three major factors when developing a system:

  • How much to trade or bet
  • The right odds or positive expectancy
  • Multiple trades or hands to play (opportunity)

How do we Calculate Position Size (stock trading example)?

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The Pareto Principle: 80/20 Rule

As a trend trader, it is likely that 20% of your trades will result in 80% of your profits so focus on riding winners and cutting losers. Learn to implement a proper position sizing methodology to your trading, ensuring that you can withstand a string of consecutive losses without going bust. A lot of people are going bust in many aspects of their lives because they are not focusing on the 20% that matters most. Forget the useless 80%, it’s bringing you down. Less is more, a popular aphorism coined by the famous architect , Ludwig Mies van der Rohe, is something I truly believe in.

It’s times like these when trend traders grow impatient and fail to cut losers and then impatiently take profits too soon (most likely shorts in early 2009). It doesn’t matter if you have multiple losing trades over the past several months as long as your overall risk on each trade is less than 2%. The Pareto Principle will even out your results in due time, assuming you have developed a known expectancy on your system and employ risk management (position sizing).

You may have an expectancy of 40% winning trades but I can almost guarantee that 80%-90% of your year-end profits come from 10%-20% of your successful trades. For example, you may have 4 winning trades out of every 10 but only 2 of those trades will supply you with at least 80% of your profits. The other two winners will be minimal or cancelled-out by commissions, slippage and taxes.

On the other hand, it’s probably likely that 90% of your losses will result from 10% of your trades because you ignored sell rules, threw good money after bad or had stops jumped. One or two in ten trades will be the culprit(s) for bringing on the most damage to your portfolio. The other losing trades will be minimal and cut quickly as you realize that they are not working out as expected.

So what is the Pareto Principle?
“The Pareto principle (also known as the 80-20 rule, the law of the vital few and the principle of factor sparsity) states that, for many events, roughly 80% of the effects come from 20% of the causes.

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Expectancy

I received a few questions about expectancy after my article on Expected Value (EV), so I decided to respond with a fresh post (expectancy has always been grouped into the position sizing and expectancy article from last year).

What exactly is expectancy?
Expectancy tells you what you can expect to make (win or lose) for every dollar risked. Casinos make money because the expectancy of every one of their games is in their favor. Play long enough and you are expected to lose and they are expected to win because the “odds” are in their favor. Most games at a casino are completed in a short period of time so they can increase their odds of winning.

The same holds true for trading. If your expectancy is positive; you can make money with a certain number of trades within specified periods of time.

Expectancy is your profit percentage per win multiplied by your win rate minus your loss percentage per loss multiplied by your loss rate. I will use an example of Expectancy from Dr. Van K. Tharp’s Book: Trade your way to Financial Freedom:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss) Expectancy = (PW*AW) less (PL*AL)

PW is the probability of winning and PL is the probability of losing.
AW is the average gain (win) and AL is the average loss

So let’s do an example using another basic approach (assume $12,500 per position, a $100,000 portfolio using 1% equity risk):

If my trades are successful 40% of the time and I realize an average profit of 20% but I lose an average of 5%, my expectancy is $625 per trade.

(0.4 * $2,500) – (0.6 * $625) = $1,000-$375 = $625

I lose 60% of the time yet I show a profit of $625 per trade. If I have a system that produces 65 trades per year, I would realize an annual gain of $40,625 (hypothetical scenario). A 40% gain on the original $100,000 (minus all commissions, fees, taxes and compounding).

Let’s look at the calculation one more time using only percentages:
PW: 40%
AW: 20%
PL: 60%
AL: 5%
(40% * 20%) – (60% * 5%) = 5.00%

What this tells me is that I have a positive expectancy of 5% or $625 per trade from the original $12,500. It doesn’t mean that I will make $625 on every single trade but my system will average a profit of $625 per trade over the course of a year with a combination of winners and losers. I can always make more trades or fewer trades in a year so my total profit will be adjusted accordingly.

What is EV or Expected Value

Let’s take a look at how EV or expected value can help us become better traders and understand how to measure risk in the market (or life in general). EV can be considered the equivalent of expectancy in the poker world so I think it’s a great read for everyone striving to gain an edge in their trading (or at least understand how an edge can be quantified).

Wikipedia Definition:

In probability theory the expected value (or mathematical expectation, or mean) of a discrete random variable is the sum of the probability of each possible outcome of the experiment multiplied by the outcome value (or payoff). Thus, it represents the average amount one “expects” as the outcome of the random trial when identical odds are repeated many times. Note that the value itself may not be expected in the general sense – the “expected value” itself may be unlikely or even impossible.

In simpler terms:
Expected Value (EV) is the amount of money you can expect to earn over time by making a calculated decision in a specific situation.

The expected value from the roll of an ordinary six-sided die is 3.5 (how do we get here):

Rolling each number has a probability of 1/6.
Multiplying the values with their respective probability gives us 3.5 or:
1 * 1/6 = 1/6
2 * 1/6 = 2/6
3 * 1/6 = 3/6
4 * 1/6 = 4/6
5 * 1/6 = 5/6
6 * 1/6 = 6/6

We get to 3.5 by adding them together:
1/6 + 2/6 + 3/6 + 4/6 + 5/6 + 6/6 = 3.5

What if the die was weighted and we know that the number “6″ has a 50% chance of coming up? We will assume that the other five numbers still have a uniform distribution (equal chance of coming up in regards to each other):

1 * 1/10 = 1/10
2 * 1/10 = 2/10
3 * 1/10 = 3/10
4 * 1/10 = 4/10
5 * 1/10 = 5/10
6 * 1/2 = 3

The expected value from the roll of this weighted die is 4.5.
We can now bet a weighed and non weighted die and know the outcome of our bets and determine the profitability, if any.

Now, let’s pretend we are flipping a coin with two betting scenarios:

Scenario #1:
We bet on the outcome, and receive even-money (we bet $1, we will win $1) on our bet. In this case, if we flip the coin 100 times, we can expect to win 50 times, and expect to lose 50 times. Overall, we win $50, and lose $50, breaking even. We have neither won nor lost any money (and over time, we will not expect to win or lose any money), so our EV is 0.

Scenario #2:
We bet on the outcome, and receive 2:1 odds (we bet $1, we will win $2) on our bet. In this case, if we flip the coin 100 times, we still expect to win 50 times, and expect to lose 50 times. But, the 50 times we win will earn us $100 (50 * $2), and the 50 times we lose we will still only lose $50. So, over 100 flips, our profit will be $50, or an average of $.50 ($50 / 100 flips). Our EV is the average win/loss per flip, or $.50. for every time this flip occurs so we can expect to make $.50.

Like expectancy in trading (a couple of trades will not give you the anticipated outcome of your system), you must understand that these EV outcomes will only take place over time, the long run. Both expectancy and expected value do not apply to short term results (we must make hundreds, if not thousands of trades, flips or rolls to expect the calculated outcome of the game.

I once read this from a poker article:
“ it’s not important to know the exact EV of a situation (in fact, with all the variables and unknown in poker, it’s generally impossible), but it is important to know whether a situation is +EV (i.e., you’ll make money long-term) or –EV (i.e., you’ll lose money long-term). It’s also generally helpful to know if a +EV situation is very +EV (i.e., you’ll make a lot of money long-term) or marginally +EV (i.e., you’ll make a little money long-term).”

I couldn’t have said this better when it comes to making trades for a positive expectancy system. We will never know ALL of the variables in the market so the most important part of a trade is to understand if the risk/reward is positive, very positive or negative.

You will be well on your way to consistent profits by understanding the risk and the potential reward of each and every trade you make. As in poker, dice or coins, a +EV or –EV can be determined even if every variable is not known. The name of the game is to play when you know it is a +EV situation or trade in our case.

The Holy Grail of Trading

I have been hearing a lot about trading systems failing or not working properly over the past few months and it makes me smirk every time. A recent article in SFO Magazine states that traditional technical analysis no longer applies due to program trading or computer algorithms making the trades. The author claims that computers don’t have emotions, therefore they don’t buy based on patterns or make decisions the way a human would. He specifically states that moving averages are now useless. Really? I guess I am screwed. Maybe this has some merit but I don’t buy in to it completely.

Traders and investors always seem to blame their systems and/ or indicators for poor performance when 99% of the time they should be looking in the mirror. They need to look in-between the ears to locate the problem. As I have explained in the past, the system is not the Holy Grail of Trading. I wrote a post last year that was missed by many since it was written shortly after the fourth of July holiday. Now seems to be the time to discuss this topic, more so than last summer.

  • What do you think?
  • What is your Holy Grail of Trading?
  • Has your system stopped working or have you disconnected with the changing market environment?

The Holy Grail of Trading:
Understanding you and combining that with sound money management rules. Conquer these two entities and you will be successful beyond your wildest dreams!

Original Post:
Do you have a wonderful trading system, one that consistently makes you money? You probably believe that you have found your holy grail but this couldn’t be further from the truth. Your system has very little to do with consistent profitability in the markets.

I often here amateur investors talk about that the “best way” or “only way” to invest and argue why their way is better than everyone else’s. The passion and energy exuded by these novice investors is wonderful but they are missing the point completely. No one can say that options are better than stocks, commodities are better than options or forex is better than everything, etc… Each investor develops a system that is suited to their own personal character traits and they use a vehicle (stocks, options, forex, commodities, real estate, etc…) that can help them reach their goals.

Investors also debate systems within a market such as: trend trading, swing trading, scalping, shorting, day trading, buy and hold, fundamental trading, technical trading, Elliot wave theory, moving average crossovers, etc… They all work if the “person” understands the holy grail of trading. And that is being able to understand YOU and how your mind works.

However, it is not the system that makes one successful. It is YOU that makes the system work properly. What do I mean? Each individual must master their own personal psychological impacts on their trading results. You must work on YOU to become consistently successful! I recommend reading The Disciplined Trader by Mark Douglas if you would like to understand the psychological trader in you.

To say that one system or vehicle is the “way to go” is ignorant.

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