Trading is not gambling although some of the Game Theory
mathematics that applies to gambling
can be of some use in trading.
Non-professional gamblers will generally not make good traders unless
they approach trading differently than
gambling. Professional gamblers sometimes approach gambling
with a careful study of the game they are
playing and Game Theory mathematics to get consistent
results; these gamblers can be good traders.
Trading may trigger some of the same addictive
reactions that gambling does in some people
but not for me. I hate to gamble but I love to trade.
I view most forms of gambling as a waste of money but I view
trading like a great game of golf.
When I go to Las Vegas I see a lot of people
putting their money on bets without really knowing
much about what they are doing. They are
untrained in the proper techniques that are needed to
win at what they are playing. The casinos
take their money without much difficulty. If one of
these Las Vegas gamblers turns to science
and becomes skilled at it then they will be permanently
thrown out of the casinos. People who approach
trading the way they lose money in Las Vegas are
just throwing their money away. Being a
trader is being a skilled professional.
However, trading is like being a skilled sports professional rather than a typical skilled
craftsperson. A skilled craftsperson gets it right nearly every time in that his success rate
is near 100%. If you play a professional sport you would not expect to achieve
such high success rates, just having a winning season is often cause for much satisfaction.
Once you know how to trade you can expect to achieve 57-59% winners. However, learning how to
trade is learning how to accept your losses as well, which are 41-43% of your trades. Losing
41-43% of the time is not always easy because the losses are not always distributed
evenly. There are times when you will have nine losers in a row and you still need
to keep your cool and be confident that you know how to trade the next trade. You need
to trade with careful risk management so that when you have a string of sequential
losers you don't blow out your account. We will discuss proper risk management many
times in this how to trade series because it is very important to your ultimate
success. Most people who are unfamiliar with risk management strategies such as the
Kelly Strategy will risk too much. Forty PH.D's were asked to play a gambling
game where they would be guaranteed to win 60% of the time but at the end of 100 rounds
only two had more then they started with because of poor risk management. You
can get everything else right and still lose money unless you manage risk correctly.
Learning how to trade is easier than many highly skilled professions but you will need to do
your homework before you trade real money. Paper trade first and only after you have mastered
paper trading should you slowly transition to real money (mixing some paper and some real).
Paper trading today is done in an electronic simulation environment, not with real paper.
When you trade you must do what needs to be done even though you may not want to do it.
Human instincts are often wrong and you must learn to resist these feelings that will lose
you money. The way probability works is important to trading but is different than your
natural instincts will lead you to believe. The Gambler's fallacy, also known as the
fallacy of the maturity of chances is the belief that your odds improve when an unusual
series of losses occur or that your odds of winning rises when you have a losing streak.
Some slot machine players will prefer slot machines that have not paid out in a while in
the belief that the chance of a payout has now improved. Let's look at a coin flip example:
if you are flipping a coin and you get "heads" four times in a row then your chances of
getting "tails" on the next coin toss has improved. However, each coin toss is an independent
event that is ignorant of every previous coin toss. Since the coin does not remember the
previous string of heads it is not biased in the next toss. If fifty different people toss
a coin in the air eight different times then the probability of at least one person getting
all heads or tails is 32.44%. That person with all heads (or tails) probably had difficulty
accepting the outcome but it is no less probable that the person who had exactly 25 heads
and 25 tails which were evenly distributed.
Another example of how human intuition is wrong is the Monte Hall paradox and
Bertrand's box paradox. You are in a game show, and you're given the choice of three
doors: Behind one door is $1,000; behind the others, $1. You pick door No. 1, and the host
(who knows the right answer) opens door No. 3, which has $1. He then says to you, "Do you
want to pick door No. 2?" Should you switch your choice from Door No. 1 to Door No. 2?
Most people would say no because their chance has not seemingly changed and Door No. 2
does not seem to offer any improvement in their chance of winning. People are more
inclined to stay with their choice once made. Staying with your choice leaves you with
a 1/3 chance of winning but changing to door No.2 increases your chances to 2/3. It is
surprising and not at all intuitive but it has been shown to be true (hence the term
"paradox"). As a trader you should learn what is true and re-train yourself to these truths
while avoiding use of your natural human instinct. Why something works in trading is unimportant,
that is an academic exercise for the curious; the fact that it works is all you need to know.
For many people it is hard to exit a losing trade and accept defeat. People who have been
reasonably successful in their life would rather hang in there and work that defeat into a
victory. This is a recipe for disaster in trading. After several disasters the aspiring
trader then over reacts and starts exiting to soon. They want to exit a trade if there is
any loss showing at all because the pain of past disasters puts them in a panic. Knowing
how to trade means limiting your losers and giving your winners room to run (we will
discuss this more later).
For this discussion "being long" means to own a stock, bond, or whatever. If you are "short"
then you have sold it after borrowing it from your broker such that you can
only profit on it if it drops in price.
