Trading without a quantifiable methodology is reduced to nothing more than a game of chance and insofar is akin to gambling. Every business model on the other hand, must also take risks, but is fundamentally different to the extent that they can quantify risks and take those that are acceptable. Gambling in essence is the practice of taking risks without knowing the probability of success. A successful Trader just like a successful businessperson must always know the odds of success before risking capital.
To eliminate emotion from these critical business decisions one must add discipline and structure to their trading routine. Each trade should be justified like any business venture or investment. It should be entered into only after a clear evaluation of the risk/reward profile. Once in the trade you must remain committed to achieving the outcome. Confidence is the great equalizer as we are less likely to second guess our decisions and let fear get the best of us.
Good practices such as risk allocation, proper investment sizing, consistent repetition, and separating emotion from trading decisions are all critical to your long-term P&L. It’s important to always bear in mind even conditions which occur 90% of the time also fail 10% of the time. Many of the 90% of the time wins at some point look like they will be one of those 10% of the losses and we must have the discipline to follow the probabilities, or we will turn the 10% into a much higher percentage of losses.
Most important to removing the gambling aspect from trading is proper investment sizing because repetition is required to realize actual probabilities. Like with any business you will experience successes and failures. There will be good & bad surprises. You should expect and plan for the unexpected. The adage “don’t put all your eggs in one basket” was never truer than with investing. By getting sizing right you are allowing the repetitions necessary to make the probabilities bear out.
It is for this reason that our P&L targets should be achieved with a higher volume of smaller trades versus fewer larger trades. Maintaining a consistency around trading repetition is also necessary to put the probabilities on your side. While it’s true any trade can be a loss, it’s also true that the margin for error goes down as the repetition goes up. And if the probabilities favor you and the trade yields a healthy risk/reward you should realize similar results to the historical data and positive P&L, if you have enough trades.
To illustrate the fatal risk of not having proper investment sizing consider the following: Due to the laws of probability, there will be negative outcomes experienced in succession. Depending on the expected probability of outcomes, these will vary from more to less as probabilities go from low to high. To illustrate the point, in a simple 50%-50% win-loss scenario, like the flip of a coin, you will not see one head to one tail ratio repeating but instead a series of random outcomes which over time will equal out to 50%-50%. As such you will see three heads in row on 12% of the flips and four heads in a row 6.25% of the flips.
Now if you allocate say 1/4 of your investment total to each trade on a 50% likelihood, all betting heads, then after about sixteen trades you will encounter four losses in a row essentially wiping out your trading balance! A good general rule for proper investment sizing is not to put more than 2% of your total investable portfolio on any one trade. Some traders may size trades differently depending on the relative risk reward ratios, and that is fine, as long as you abide by the 2% maximum rule.
Another example of this that most people have experience with and can relate to is the business model of the Casino. It’s not uncommon to see people winning while gambling at the blackjack, roulette and craps tables. The Casino has a very simple model – they maintain quantifiable edge and although they may not prevail in any one game of chance or with any one gambler, over the repetition of games, the odds will prevail in their favor.
Now suppose you are the Casino, and you have the odds in your favor, but you change your policies. You decide to allow a player to bet unlimited amounts of money on one bet and then the house loses. Or you decide that while going through a losing patch you are going to take your losses and close the business before the probabilities can bear out where they should be, back in your favor. Or you decide to promote the business by changing the rules that accept odds in the player’s favor. Or you create a new game where you don’t really know the odds of success. These are all behaviors a successful business would not do and nor should you – Yet those are ways of many a Trader.
With trading as in business there are no silver bullets. Every good strategy relies on strong execution. Certainly, strong execution or any execution for that matter doesn’t go anywhere without the right strategy and ultimately any strategy is dependent on having sound information.
QuantDirection can provide that sound information with which to assess probabilities. And with analytics wrapped around this data you can go further by comparing strategies and exposing where the best opportunities exist at any point in time. All of this together can mean the difference between gambling and sound business judgement.