Is trading anything like casino gambling? It’s a common question, or even outright claim by some who think financial markets are random or simply risky. The real answer is that it depends. Do you have a viable strategy that understands the root cause and effect relationships of what makes financial markets move and employ trades that take advantage of that? You will spend years and decades refining this. Ninety percent of the people who go to Las Vegas lose. Yet in most of the games the odds of losing are only 65%-70%, sometimes less. So why do most people lose?
Naturally people want to make money. So when they’re down, they keep betting more and more to recoup their losses. This ends up going badly because the odds are skewed against them and their “risk management” becomes worse. And it ends up with more people losing than you might expect going off the basic odds.
In trading, you often hear the term “bet” to refer to a trade and the word “game” given to markets. Trading is certainly not about blithely betting or playing games, but it’s an appropriate analogy considering the similarities between the two – knowing reward and risk, sizing positions, and tilting the odds in your favor.
Trading As A Business
Trading and investing is like any other business where the idea is to generate cash flow off the assets at your disposal. It’s about making the best decisions to ensure that the business can turn a profit and generate consistent cash flow.
Company decision-makers don’t come to work each day with the idea that they’re “gambling” or just randomly doing things and hoping that something works. They have a plan and try to effectuate it in the best possible way.
Know Your Reward Relative to Your Risk
The best traders really understand risk and reward. They size their positions on the basis of this reward to risk relationship, such that their top ideas – i.e., the ones with the highest odds of working out – are the ones that are most likely to lead the portfolio.
When it comes to any idea, there are probabilities involved. For example, when credit spreads become very tight toward the top of an economic cycle, betting on credit spreads widening becomes a trade with high reward relative to its risk.
Or, for institutional traders who have access to credit default swaps, insuring safe sovereign bonds (such as German bunds) against default often costs as low as 5 basis points (0.05% per year of the total value of the bond). However, during a recession, that cost can often be 40 basis points or more. Your maximum loss is just that 0.05% per year, while your gain can be much, much higher.
Fundamentally, you want to recognize opportunities where there isn’t much to lose but a lot to gain. This can be a good idea even if the probability of the profit-making outcome isn’t particularly high. For example, if you perceive your reward to risk on a particular trade is 5x, but the odds of that occurring are about only 30%, that trade is probably still worth putting on. It would be the equivalent of sacrificing $100 to win $150, for example. If you take enough of those bets you’re likely to come out ahead.
Be The Casino
Casinos operate by only offering the games they know will skew the odds in their favor. This is the same for successful traders. They need to take trades that give them higher odds of winning.
Casinos also have minimum and maximum bet sizes. If they didn’t have minimum bet sizes, some customers’ values would be too low. On the other end of the spectrum, if bet sizes are too high, casinos run the risk of a large bet blowing a hole in their returns.
For example, if a sports book has $500,000 on each side of a bet, it knows that regardless of the result of the matchup, it will make money. However, if a bettor were to come along and try to place a $750,000 bet on one side or the other, if the result goes against the book, that can lead to a very unprofitable outcome. It could also wipe out the profit derived from other games offered by the book. Accordingly, to limit the potential damage, casinos will usually look to cap bet size.
Similarly, for traders, you don’t want to bet too much on any given thing no matter how confident you feel. There is always the tail risk that the trade goes against you. It’s a basic matter of proper risk management. Capital preservation is key. You want your long-term edge to be in finding asymmetrically favorable reward to risk set-ups, not in “betting the house” on any particular outcome.
Casinos also have longer hours than normal businesses. Most brick-and-mortar businesses, especially small businesses, are open only 40-50 hours per week. Casinos, on the other hand, are often open about 100 hours per week. Online casinos are of course open 24/7/365 as they serve players globally and need to be accessible in all timezones. This helps ensure a diverse array of customers come through the doors and maximize revenue and profitability. The implication for traders is to focus on the fact that a variety of trades – hundreds, probably thousands – over the course of a career will determine your performance, not a small selection.
Is trading gambling? In many ways the two disciplines are similar. If you are taking a bunch of virtually even-probability trades and haphazardly trading the market, then you will probably lose much in the same way your average gambler loses in a casino. Similarly, if you have poor risk management and size bets higher the more you lose, you will probably lose even more and at a faster rate. This is much like how casino-goers lose more money than the odds would dictate.
Casinos will pick the right business strategy by:
- Only offering games that give them an edge.
- Instituting a maximum bet size to protect profit.
- Elongating the number of hours they remain open to encourage a diverse assortment of customers.
In the same way, traders need to:
- Only take the trades that give them the highest reward relative to their risk.
- Size positions appropriately such that no trade dominates their profit and loss numbers.
- Spread their trades out so that their cumulative performance is a function of a diverse selection of high reward to risk trades, while also reducing the volatility in their performance.
All traders must take a long-term approach toward their trading careers. You will not make money every day, every month, or every quarter. Even the best traders and investors of all time will have losing years.
Moreover, the best traders are totally unemotional about profit and loss numbers. If you have a viable strategy for identifying and taking quality reward to risk trades, losses should not affect you because you will view them as simply driven by probabilities. This means sometimes a trade will go against you. It’s the nature of how odds work. A bad day, a bad week, a bad month, or the occasional bad quarter should never influence how you approach the markets going forward.