Traders can Learn from Gamblers

Whenever I present a seminar to an audience of beginners, or write a blog post directed to people who do not yet know much about options, it's always important to warn these option rookies that they mustn't believe everything they hear. For one, options receive plenty of negative publicity and too many financial professionals consider the use of options to be gambling. 

These stockbrokers steered their customers away from using options by propagating a myth.  And if that's not enough, they also tell clients that options are too difficult for the average investor to understand.  Such brokers did their clients a great disservice.

There's much hype – all over the Internet.  As a result these investors must be careful to avoid the scams.  Some companies (or individuals) charge big bucks for introductory options lessons, when equivalent information is available at little, or no cost.  There are decent folks selling instruction, but it's not so easy to find them among the unethical.

Then there's the group that wants to teach you how to earn 5 to 10% per month – every month, with no losses.  Plenty of people fall for that, although common sense would tell you that these are unrealistic returns (One dollar becomes one million dollars in just over 12 years when compounded at 10% per month – ignoring taxes).  But too many novices pay for information first and only realize how foolish they were later. A good marketer knows how to grab attention, get people excited about unreasonable expectations, and smile as suckers willingly hand over their money.

I must mention that some people are honest.  They provide audited trading results, give you the opportunity to verify that the results are audited, and make good money.  It's okay to pay these folks for advice.  The point is that it's difficult to single them out from the scammers.

Gambling vs. Trading

Many option rookies are attracted to options because of stories about people making millions – very quickly – by using options.  Or sometimes the story is closer to home and they have a friend who bought some calls (or puts) and made $10 for each dollar invested.  It's easy to get excited when you hear 'how easy it is' to make quick money with options.

People love to gamble.  Lotteries sell the dream to people who cannot afford the cost of the tickets.  I suggest that rookie option traders avoid gambling with options.  But human nature leads many astray.

Is investing gambling? 

Technically it can be considered gambling.  If you buy stock, bonds, options etc. with the hope of selling later at a higher price, you are, in the technical sense, placing a bet.  That is gambling.

What separates gamblers from investors is the idea that investors have opportunity to gather information on the company whose stock they are buying, or the 'background' on the options they are trading.   Stock traders have fundamental reports on how the business is doing, or has done over the years.  They also have price and volume charts which allows them to perform technical analysis.

Option traders can look at implied volatility to get an idea of whether the option is priced reasonably.  They can also do the same fundamental or technical analysis on the underlying asset.  

It's true that a bettor can get the horse's (or football team's) past history as well as that of the competition.  There is a similarity.

The good news is that investors can learn from gamblers.

Dr. Brett

Regarding gambling and investing, Dr. Brett recently posted about how certain aspects of gambling can be intelligently applied to trading:

"When trading is compared to gambling,
the implication is generally negative: that traders are little more
than people who roll dice in hopes of a big payout.

There is another side to gambling, however, typified by the card
counter. The card counter, dealt a hand, is aware of the odds of
winning with those particular cards. The counter also follows which
cards have been dealt already, dynamically updating the odds…

Yesterday's market is like a set of cards dealt to us

As this analogy makes clear, a major source of trading edge becomes the decision to not trade.
Just as a professional poker player will muck [fold] many hands when the odds
are unfavorable, giving up a small amount to preserve the opportunity
to bet large when circumstances are more favorable, the professional
trader does not need to trade. Rather, the trader bets when the odds of
winning are enhanced."

Keep in mind that Dr. Brett's advice is targeted to traders who hold positions for a very short time.

This specific advice still has appeal for traders who hold option positions for weeks or months.  Too many traders feel the need to be 'all in' and are always invested.  If that's part of your overall strategy, at least consider trading less size (fewer options) when conditions are not especially favorable for your chosen strategy, and perhaps increasing the size of your trade when conditions are more favorable.  

The card counter makes a large increase in bet size when the odds are improved.  You cannot do that – because conditions change so rapidly and you are invested for a longer time.  But you can open slightly larger positions when you like the odds of success, and slightly smaller trades at other times.

Sitting on the sidelines, waiting for better opportunities, is a mandatory practice for day traders.  It improves the odds when trading.  Iron condor traders seldom have the patience to observe the markets with no positions.  But decreasing trade size is one way to 'partially' observe the action with less at stake. 

We may not be able to count the cards, but we can see situations that provide extra reason to be optimistic or pessimistic.  There is no reason not to trade accordingly.


12 Responses to Traders can Learn from Gamblers

  1. Don 01/21/2010 at 7:09 AM #

    Fantastic Article!

  2. Roger 01/21/2010 at 12:09 PM #

    Very helpful post, Mark, thanks. You wrote recently about how your own positive expectancy is determined to a degree by your personal trading rules. In addition to considering past experience and the deltas of option positions, is there a method that rookies can use to better anticipate what our positive expectancy should be under various conditions, such as using different trade exit rules, or varying the amounts of pre-insurance or kite spreads to be bought? It seems there is enough gray area in deciding when/how to get in/out of condor positions that one could lurch around for a very long time trying different variations before creating a satisfactory set of trading rules for oneself.

  3. Jared 01/21/2010 at 12:24 PM #

    Hi Mark,
    I have a question regarding risk management. I currently have a position on in the RUT. Approximately a $13,000 position. It is a mixture of 20 point iron condors and 30 point double diagonal’s (Selling options with a 20 Delta for both). My profit at the close yesterday was $300. As I speak (intraday) the current p/l is -$22 dollars. The RUT has moved down approximately two standard deviations(1 day), so there was a big move today, at least intraday. My question is, should I be down this much money? Is this normal? In other words I was up $300 yesterday and the stock has moved now two (1 day) standard deviations and I find myself with no profit, is this characteristic of a bad risk manager? Is the fact that I had a $300 profit and am now back to zero a bad thing, a very bad thing, or completely normal on a $13,000 position? Just wanted to know what your thoughts were on the subject.
    Thank you.

  4. Mark Wolfinger 01/21/2010 at 12:28 PM #

    I’m not certain that everyone can find satisfactory trading rules.
    Yes, there are lot of gray areas.
    Getting in: Watch your size carefully. That’s risk management step number one. Pay attention to your comfort zone – that does not mean to panic, but if worried, then the position is not for you.
    Insurance and kites? These are not for everyone. They cost real cash. Only you know just how much protection to seek and the price to pay. I truly have no guidelines, nor do I have a consistent stance on this aspect of trading.
    Exit rules: Too little to gain, so exit. Sufficient profit earned can be a reason for some to exit. I prefer to pay attention to today’s risk/reward and make a decision.
    I’d like to help, but so much of this is personal and to some extent emotional (although minimizing that is advantageous), that there is no advice I can offer that suits everyone.
    Minimizing risk and earning money are your goals. If you meet them – and if you believe you accomplish those by making good decisions, and not by being lucky – then you should be satisfied with what you are doing.
    More experience will give you good information to tweak what you are doing.
    Major advice overall: If you are doing well, do not get over-confident. Be as diligent as ever managing positions.

  5. Mark Wolfinger 01/21/2010 at 12:58 PM #

    reply posted as new post

  6. Roger 01/21/2010 at 2:52 PM #

    Thanks, Mark.

  7. soemardi 01/21/2010 at 5:32 PM #

    “I must mention that some people are honest. They provide audited trading results, give you the opportunity to verify that the results are audited, and make good money. It’s okay to pay these folks for advice. The point is that it’s difficult to single them out from the scammers.”
    can you give example some of this? if you dont mind

  8. Mark Wolfinger 01/21/2010 at 7:36 PM #

    I’m sorry. I can’t.
    I don’t want to be in the position of recommending anyone.

  9. Andy 01/21/2010 at 11:39 PM #

    I feel a fundamental problem is that we are led to believe the market moves in rational/predictable methods on a day by day basis. I receive multiple email solicitations regularly from pay services claiming they know what the ‘hot’ stocks will be in the next day or two… but the mentality of rationalizing the market pervades everywhere. From when I log onto yahoo finance in the morning to the financial tv shows I watch in the evening, it seems everyone has a clear explanation for every upward and downward bump for the day’s market.
    When I first started trading/investing, I invested in several stocks that I was convinced would be winners… I was influenced by the “can’t lose” mentality that was out there. When those stocks failed to meet my expectations, my mindsetting flipped and I almost quit, feeling the whole process was the same as gambling.

  10. Mark Wolfinger 01/21/2010 at 11:51 PM #

    Whether the market, and its participants, are rational is very different than saying the market is rational on a day to day basis.
    It’s easy to find something that explains why the market behaved as it did. Even when it’s nonsense. People lap it up. But ask one of those bozos to tell you what the market is going to do tomorrow and they have no answer.
    I have a question for you: Why do you watch those shows? Do you gain anything? Does the screaming moron on CNBC ever tell you anything useful?
    As far as I am concerned, it is gambling when you trade those tips.
    You have no idea how the trade was selected or whether it’s appropriate for you and your risk tolerance.
    People who sell ‘picks’ and don’t care to whom they sell those picks are doing a dis-service to the world. But why should they care? If you are dumb enough to send money, they are smart enough to take it.

  11. John (aka The Masked Financier) 01/22/2010 at 7:31 AM #

    An excellent article and one close to my own heart as the creator of the Texas Holdem Investing method for learning to invest.
    Texas Holdem Investing uses poker as a tool and medium to teach some of the key elements of successful investing and trading, namely:
    – Learning the securities you intend to trade
    – Creating a business plan and adhering to it
    – Sizing positions for trades
    – Cutting from losing situations quickly
    – Risk management
    – Emotional control
    Also, in terms of bolstering the link between options and poker, as I’m sure you are aware, one of the top options trading firms in the world is build around poker – Susquehanna, and poker forms a part of the hiring and training process at this firm:
    Keep up the good work,
    John (aka The Masked Financier)

  12. Mark Wolfinger 01/22/2010 at 8:20 AM #

    Thanks for the comment. Yes, I am familiar with Susqhehanna.
    No one in the investing world likes to think of it as gambling, but the similarities are obvious.
    In a hurried peek at your site, I note that you offer your book for free – online. Nice