By Jay Maniar
Well, this is a sequel to the previous blog Trading & Gambling: Lessons Traders Can Learn From Professional Gamblers and by now, many would be thinking that what really can the traders learn from these professional gamblers? Maybe there is more, maybe not! You may read this blog and decide for yourself.
In the previous blog, the first lesson that we covered is to bet, or in case of markets, ‘trade’ only what you know. Further, we even understood that a Disciplined state of mind is necessary when you trade. If you must play, decide upon three things at the start: the rules of the game, the stakes, and when to quit.
Let us begin with the third lesson:
3. COUNT - Do the Math and understand the Expected ValueBefore we start understanding this, I would like to place a bet with you. You may choose any of the following bets to bring me down:
I would like to go out for a walk with you, in a nearby garden for 10 minutes. We will talk about politics, life and philosophy (or maybe just have a drink and chill out). During these ten minutes, if a bird beats (bird dropping) on you, I will pay you $10,000* or else you will pay me $500.
*Terms and condition: The garden should be agreed upon by both the betting parties amicably.
You draw an ace of spade from a fair card deck (shuffled by a third party), you will win $1000. Else, I will win $50.
Case 1: We will roll a fair dice. Choose your lucky number. If that number appears, you will win $500 and if not you lose $250.
Case 2: Let’s say you do not have a lucky number from 1-6. So let's say if 2 appears on the face of the dice, you win $500, else you lose $150.
Let's try playing roulette. If your ball ends in the red pocket you win $50, you lose $50.
Trust me, I WILL ALWAYS WIN at the end of the day. Yes always! If anyone thinks this is a hyperbole, you will not be the only person I would be playing with. I will be playing this with everyone who comes to me, day in and day out, 365 days of the year. But still, isn't ‘ALWAYS’ a bit of a hyperbole. Well maybe, but hey, if you wanna bet on this too, you are welcome to my casino to bring me down.
While trading, it is necessary to do the math for the instruments that you are going to trade. For eg: If you are long a Call option, what would be the probability of your option ending in-the-money (ITM)? A simple answer would be the delta of the option. If the delta of the option is 0.3 then it implies that at this point in time, your option is out-of-the-money (OTM), and the probability of the option ending it in the money is 30%. Hence you should buy accordingly. (your premium payment)
Well, many retail traders ‘buy’ options. They either go “Long Call” or “Long Put”, pay a premium and wait for the option to go in-the-money. Do you know this fun fact? 85% of the time, these retail traders lose premium and the option writer wins. If you do not believe me, you may search this up on the internet.
Anyways, coming back to the above 4 bets, why will I ALWAYS win? Or would I have betted had that always not been the case?
My Expected Value = [(Probability of me winning) * (Amount I will win) - (Probability of you winning) * (Amount I will have to give you)]
EV (Bet 2) = [(51/52) * $50] - [1/52 * $1000] = $49.03 - $19.23 = $ 29.28Please note my positive $29 EV on the Bet 2.
EV (Bet 3) Case 1 = [(5/6) * $250] - [1/6 * $500] = $208.33 - $ 83.33 = $125
EV (Bet 3) Case 2 = [(5/6) * $150] - [1/6 * $500] = $125 - $83.33 = $41.67
In the Bet 3, I have done one more thing. By letting you choose your own “lucky number”, I have given you a feeling that you will be able to control the outcome. Even though the probabilities of me winning and you losing is the same, I have introduced a behavioural bias and now I am going to earn more on that. (The case 1 EV is greater than the case 2 EV). Yup, you are still welcome to my casino.
EV (Bet 4) = (0.5 * $50) - (0.5*50) = $0 (No profit, no loss EV). Basically, Bet 4 is to keep everyone busy at my casino.
And well, the bet 1 is a random event and is not in my hand or your hand (or should I say something else instead of hand). I can't really quantify, how, when and how many birds will beat (their droppings) on you. I can, but won't be able to explain it in simple words. (If you think I can’t, wanna bet? :P). By the way, have you heard of crowd pullers? Yes, the bet 1 is the crowd puller at my casino. Still, let me “count” my risks in the bet 1. If I play this once in a day for 365 days, and if I win every day, then I would win $500 * 365 * 1 = $182,500. Hence I can afford to lose 18.5 times in a year, and there would be no profits, no loss. (I hope you understand that even if I lose 20 times, my casino would still be in a profit because of my positive EV on other games.Another lesson: Look at your portfolio as a whole while trading and not based on isolated trades and mental accounting)
Yup, that’s my casino.
4. Manage your resources well - Your Capital and a realistic ROIHave you observed, how well I have managed my resources while setting up my casino and how realistic I was while calculating my returns (by being realistic, I mean all I expect is the “Expected Value” and nothing more.)
Hence, if you have a capital, you diversify your investments and allocate the capital accordingly to the different asset classes. You should always know the risk and quantify it. Further, the reward is always based on the risk that you take and hence your expectations should be realistic, and similar to the way a casino’s expectations are realistic.
This is where I would like to sign off. Do comment, if you like the blog and let us know your views.