Are you trading or gambling?

Do you want to be a gambler or a professional trader? I’m guessing most people who read this would prefer the latter. But are you sure that you’re not a closet gambler?

I used to read a lot of trading books. Back in the early 90’s I started the habit of reading large volumes of trading books. I read everything. Technical analysis books, money management books, trading psychology books, trading memoirs, trader interview books,  you name it, I read it. It took me many years and plenty of time in the business to realize how similar most of these books really are.

Trading books that target retail traders follow the same theme. They use the same terminology and the same established school of thought. Established by other trading books. They reinforce a certain way of thinking.

The approach that they are based on is usually very far from how the industry works. They favor a very romanticized view of trading, where a trader is the lone ranger cowboy, fighting his corner against the market. The idea of what a trader is and what he does is greatly distorted. Even more so, the idea of how he does it.

A trader by any other name

In the financial industry, there are extremely few people who do what trading books talk about. People who sit around and trade their own book with complete freedom are practically unicorns. If you work for a bank and have the word Trader in your title, you probably do something very different from what most people think. Most are just brokers, sales guys or execution traders. Sure, we have the prop desks, but they’ve traditionally been about flow trading. Essentially front running clients, since they know the internal order book at the bank. Yes, they shouldn’t know this and the banks tell the clients about Chinese walls, compliance and procedures, but come on. We’re all grownups here. Much of this has ceased at this point, as regulators have started getting rude enough to actually try to enforce some of their regulations lately.

Mutual fund managers follow an index with a very tight tracking error budget. They invest very closely to the index and over/under weight a few issues that they like or dislike. Quite far from what you read in trading books.

But what about hedge funds? They often have more freedom than others, but there are still not many funds trading like you’d read about in most trading books. It looks very different on the inside.

Money management or money manager?

There are many odd aspects of the illusion of trading that’s been established by this flurry of trading books. I’ve mocked magical numbers and holy wave counts before, but there are other less obvious problems. Most rational people can figure out that there are no magical numbers governing the universe, but what about the field of money management?

The problem starts with the word itself. It’s a gambling term. The generally established way of looking at risk in retail trading books is based on ideas from Las Vegas. Pyramiding is a great example.

So the general idea would be that you increase your position size after success. Say you buy at 100 and after a week the price is up to 110. Since we’re now playing with the house’s money, we can increase the trading size. Right? If this is your way of thinking, you should stick to the black jack tables.

The fact that you entered a week earlier has exactly zero impact on probabilities for future price moves. Your past p&l is not a factor. There’s no rational reason why you should take on a higher risk just because you now have an unrealized gain. This is the equivalent of placing everything on red after black came up twice in roulette. It’s just based on a lack of understanding of statistics.

There are many odd aspects that always come back in the money management chapter of books. Risk of ruin is another. If you worry about risk of ruin, you’re already far into the realm of gambling. If ruin, as in blowing up the account, is even in the realm of imagination then you’re doing something wrong. Losing half of your portfolio is an absolute disaster from which you will likely never recover. Remember that if you lose half, you need to double to get back to where you started. Losing a third is pretty bad. But if you’re aiming at just short of risking losing everything, than you’re a gambler. Not a trader.

Most position sizing approaches mentioned are also from the gambling world. Both terminology and methodology tends to be written from a Vegas point of view. Of course, many of these books are written by people who claim to have turned a few thousand into a few million in short periods of time. That only leaves two possibilities. They are either lying or they are gamblers who got extremely lucky. Either way, you probably don’t want to apply these methods yourself.

It’s about volatility

It’s all about vola control. This business is not about who had the highest percentage return at the end of the year. It’s about how you made it, at what vola. Volatility is the currency we use to buy performance. You want to spend as little vola as you can to buy as much performance as you can.

This concept is often dismissed as something that institutional guys and hedge fund managers need to deal with to please customers, but not relevant for anyone else. After all, you’re just interested in the return.

Well, there’s a reason we operate like this. The vola is a measurement of risk. Taking crazy risk to get crazy returns is not professional. There are lots of guys who did that and won, just like there are lots of guys with anecdotes about how they flipped a straight flush on the river. Those guys don’t last. They come and go. They are loud when they’re winning and they disappear when they blow up.

Vola control is not there as some check box to please demanding institutions who don’t know any better. It’s there because it makes perfect sense.  Spent vola must be justified with performance.

Vola can be measured in different ways, but the more important point is that it can, and should, be measured both on a position level and portfolio level. In the end, it’s the vola and return on your portfolio that matters. Too much focus on the the position level distracts from the far more important portfolio level. Position sizing, and resizing, need to take the portfolio into account. That last sentence is extremely important.

Stay in the land of reality

The single most important thing that differentiates a professional from a doomed amateur is expectations. All these retail literature has indoctrinated people with idea that a good trader should have double digit yearly returns. 10-15% per month, every month. At least. With that kind of unrealistic starting point, of course the gambling methods seem attractive.

Look at it this way. The very best in the world don’t compound at double digit percentages. They might have an extreme year in that region, but they’re not aiming to stay there. Most of the time when you hear of a hedge fund manager reaching those numbers, it’s because he saw a single extreme probability deal and bet big. Sub primes for instance. Or for my part of the business, when the crash of 2008 shocked trend followers by pouring money into our account at an unprecedented rate. Most of us cut down risks dramatically that year, despite the big profits. Risks were skyrocketing.

A trader who can compound at 15-20% per year over time is very good. One who aims at compounding at 100% is a gambler, not a trader.