A young person recently asked me for some career advice. In my academic days I advised many students, of course, so the question was a familiar one. This person wanted to enter the trading world. The most important aspect of my advice was as follows:
Be sure to find a good game.
She asked, of course, "What does that mean?"
My definition of a good game is one where your theoretical edge will show up within sufficient time. This may mean before your trading account runs out, you lose your clients, or you lose your sponsors.
In a good game you get into "the long run" fairly quickly, and use money management to make sure that risk is controlled. We emphasize that investing (or trading) is not gambling, but the mathematics of the gambling literature is quite applicable to trading. Casinos have a good game, since they have a known edge and can get into the long run quite quickly. Despite this, short-term results (and earnings) are influenced by the performance of "whales", the big bettors who take big chances.
Ken Uston's excellent book, Million Dollar Blackjack (now featured on our reading list), describes both his system and the implementation in team play. Card-counting nerds would signal "the Big Player" who would seem to flit from table to table, cocktail in hand and a woman on both arms. The team used the Kelly Criterion, treated extensively in William Poundstone's book, Fortunes Formula which we discussed in this post.
As a result of this team method (no longer effective given casino counter-measures), Uston played exclusively in situations where he had an edge of about 5%. Despite this advantage, he describes a period of time where they had a losing streak lasting more than a month! Please note that this includes thousands of hands played.
Most gamblers, and probably many traders, make the mistake of over betting their bankroll, not realizing the devastating effect of a losing streak that should be entirely predictable. Effective money management cannot turn a losing system into a winner. Ineffective money management can doom even the best system.
What is a Good Game for Trading?
Dr. Brett Steenbarger's recent post, "What We Can Learn from Trading and Poker," provides focus on this issue. Time frame is important.
Here are the key time frames:
- Intra-day. Technical setups occur frequently. If one has a good system, the long run can occur very quickly and a modest edge can yield big profits. Many trading firms now use software that identifies small advantages and makes quick moves through automation. This is the competition for the intra-day trader.
- Short term. I define this as trades lasting a period measured in days. We employ an excellent system for short-term trading. It is over-simplifying to call it "mean reversion" but that is the basic concept. Vince, our modeling guru, identified key concepts and measured them in a unique fashion, drawing upon advanced mathematics. Even with such an advantage, one must expect losing streaks that can last for weeks.
- Intermediate term. This is a period that is projected in weeks, often based upon technical indicators. Vince has developed an excellent trend-following method, once again using his own special methods. It is this model that we employ in our weekly responses to the Ticker Sense blogger sentiment poll. For the moment, we have made these calls public in the poll. The method can lead to gyrations at market turning points. In the last few weeks it has steered us to be long, neutral, and short (currently long). Such a system has the advantage of getting on the right side of the market for major moves and avoiding major losses.
- Long term. This is the realm of valuation, and macro analysis of fundamental trends. It describes much of what we write about on "A Dash." The problem with long-term market calls is that the scenario might take a lot of time to play out. The debate between bearish analysts and those seeing great value in the market is now in (at least) the third year, with few viewpoints changing. The extended period of Fed rate hikes and the debate over the economy has prolonged the issue. While we see it as a period of undue negativity (with evidence here), others continue to see an imminent recession.
There are two main lessons.
First, the edge one needs must increase with the time period. A good game requires getting into the long run. The long run is not measured in time. It is measured in the number of independent opportunities to make a "bet." One should not invest or trade on a long-run call without the expectation of substantial edge. Having made such a decision, patience is required. One holds on until victory is achieved or the evidence changes.
Second, it is important to choose a trading or investing strategy that is geared to the expected edge. This means careful attention to position size.
This is a framework for analysis, and a key concept for traders and investors -- or poker players!