In order to explore the relevance of gambling to trading, it may help you to see how playing various popular games of chance — including coin tosses, poker, blackjack and roulette — can also apply to trading and where the key differences between these risk-taking disciplines lie.
This topic is covered in greater detail in the sections below, in addition to why traders should think more like a gambler and generally rely on assessing the odds of winning on a trade instead of on the economics of the asset they are considering trading.
The Coin Flip or Toss
One of the oldest and most basic probability models is the coin flip. Just like in the capital markets where you trade stocks or other assets that have complex fundamental situations, the results of a coin toss involve many factors. These include the initial position, force of the toss, gravity, humidity, number of rotations, etc. Like when you are analyzing the price of a stock or other asset, if you have precise information on all the variables affecting the coin toss, an accurate assessment of the results of the toss could theoretically be attained.
Furthermore, if you looked solely at the force of the toss, for example, you would probably not get a precise determination of the result, although knowing two or more factors might increase the accuracy of your prediction. Predicting stock prices has many parallels, which argues for knowing and assessing as many key factors as possible that would contribute to a stock’s price increase or decline.
By using a probability model and information about the asset when trading, a more accurate prediction can be made about the likelihood of a rally or a selloff. For example, using a stacked coin is similar to trading in a financial market that is trending. The odds of a movement in favor of the trend are typically greater than moves against the trend. As the old trader’s adage goes, “The trend is your friend” in such markets.
Poker is another game of chance that relates especially well to trading since you play against other players in both arenas. Poker played against other people can be lucrative if you have excellent discipline, patience and skill, especially if you have either a large inheritance or another source of income.
Additional similarities between poker and trading consist of the risk of losing money, the need for prudent money and risk management, and being able to calculate value in an imperfect environment while controlling your emotions.
Applying these principles can be simpler with less variance in poker than with trading. Also, poker does not rely on external influences and has no supply/demand variable like trading does. Furthermore, unlike poker, trading requires that proper research and market analysis be conducted before making a transaction. Regardless of whether the analysis conducted is technical or fundamental, without performing sufficient research to assess the odds of winning, trading becomes little more than gambling on a coin toss.
The prudent choice of opponents in poker is another important element of success as a skilled poker player, since you gain an edge by choosing weaker players. This does not really have a parallel in the trading arena since you trade against a variety of other market participants you cannot select. You can however still copy winning traders or use a good trading algorithm to improve your odds of profiting from your market bets.
Blackjack shares a number of parallels with trading, which is the reason that many talented blackjack players become traders after being banned by casinos. Some well-known blackjack players who have become successful traders include Ed Thorp and Blair Hull. Another is Bob Bright, who is also a world-class poker player.
Because blackjack and trading require practically the same skill sets of knowledge and discipline, the transition from blackjack to trading can be quite easy for many proficient players. Good mathematical skills and a solid base of knowledge are required in both trading and blackjack to make quick and sound risk-taking decisions.
Furthermore, success in both arenas requires mitigating risk to avoid losing money. In blackjack, “basic strategy” is employed to even the odds with the house, while counting cards tips the probability of winning slightly in the player’s favor. A similar betting strategy used in blackjack can also be employed in trading using prudent position-sizing and money management techniques to give you the ability to absorb a string of losses without going bust.
The most important element in trading, however, consists of having and executing a sound trading plan developed after first educating yourself thoroughly about the market. Keep in mind that having any trading plan is probably better than having no plan at all.
Blackjack players typically plan their bets by adhering to the basic strategy they have learned. They also generally use a strategy for counting the deck, which could be a single deck or a set of five decks contained in a “shoe” that is commonly used in casinos.
If the trader or gambler relies exclusively on luck, a good chance exists that their time at the tables or in the market could be short-lived, since their good luck will eventually run out at some point. In blackjack, as in trading, a plan ought to be followed in a disciplined manner to mitigate losses and keep emotions at bay by sticking to the strategy.
With respect to determining the potential value of a bet and how much to stake, blackjack players need to know what cards have come out of the deck. The current card count alerts the gambler to an increased likelihood of a blackjack, which in turn leads them to increase the size of their bet.
In trading, spotting value means getting information about an asset that suggests an increased chance of a price move in a particular direction. Knowing when to get in and take risk or when to stay out and “sit on your hands” are therefore key elements to success in both trading and blackjack.
The primary similarities between trading and roulette consist of betting on a forecast for a profit and the fact that both trading and roulette have been perceived to have patterns.
Furthermore, the simple red/black bet in roulette is quite similar to trading a binary option where you gain a fixed payout on one side of the strike price if your market view is correct, or you lose a fixed premium on the other side of the strike.
Using technical analysis to find chart patterns in a market could also be akin to finding a roulette wheel with a pattern bias. Performing fundamental analysis to assess the probability of a market rise or fall could also be compared to the probability analysis typically used by seasoned gamblers when playing roulette.
Why You Should Trade With Probabilities Instead of Economics
The main reason the majority of professional and non-professional traders lose money in the financial markets is that they typically approach trading using an economic model versus a probability model. Since successful gambling has its basis in determining probabilities, i.e. assessing the odds of winning as accurately as possible and betting accordingly, adopting a probability model for trading makes sense in most cases.
For example, many economic factors contribute to the price of a stock or other financial asset. If one could identify all of the factors involved, an accurate prediction of the future price of the asset could be ascertained — in theory anyway. This could allow for an economic model to provide accurate stock price predictions, although many influencing factors are either unknown or not taken into account when trading most assets, and this contributes to the unpredictability of price movements.
This complexity also drives analysts and traders to isolate some elements that could influence price, but not all, thereby making their predictive value questionable. One such factor consists of the price/earnings ratio. If you simply consider the price of a stock versus the amount of money the company makes, then a company with a low PE ratio would be undervalued and vice versa.
In reality, the PE ratio of many companies’ stocks reflects factors not readily apparent in the pricing of the stocks. These factors can include the expectations and perceptions of the public and the investment community, with the latter factor being arguably the most important element.
TheFXperts’ blog posts are provided strictly for educational purposes and represent the opinions of the authors. No recommendation or endorsement for specific financial trading or investment purposes is offered. Subscribers are advised to seek financial, business and legal guidance from licensed professionals.