Saturday, October 27, 2007

Trade Like a Card Counter

In two recent posts, I have outlined baseline odds of prices hitting various benchmarks, including the prior day's highs and lows and the previous day's average trading price.

What makes trading interesting is that these odds shift dynamically: as markets move, so do the odds of hitting those benchmarks. It is the inability of market participants to adequately update their outlooks in the face of recent events that creates one important source of short-term trading edge.

When trading is compared to gambling, the implication is generally negative: that traders are little more than people who roll dice in hopes of a big payout. There is another side to gambling, however, typified by the card counter. The card counter, dealt a hand, is aware of the odds of winning with those particular cards. The counter also follows which cards have been dealt already, dynamically updating the odds that new, favorable cards will be forthcoming. It is this knowledge of odds--and the ability to update them in real time--that makes card counters so formidable that they are banned in many casinos.

Yesterday's market is like a set of cards dealt to us. Then we get a new card with the overnight market. The market open provides yet another card. All the while, the new cards either improve or fail to improve the odds that we'll hit target prices as the day moves forward.

As this analogy makes clear, a major source of trading edge becomes the decision to not trade. Just as a professional poker player will muck many hands when the odds are unfavorable, giving up a small amount to preserve the opportunity to bet large when circumstances are more favorable, the professional trader does not need to trade. Rather, the trader bets when the odds of winning are enhanced.

Such a trading approach emphasizes the exit--the target price--as well the entry. Yes, it's important to get as good an entry price as possible, but it's knowing the odds of hitting those benchmark prices that ultimately define the good trade idea if you're trading like a card counter. By controlling the bet size--not going "all in" on any one idea and risking ruin--and by exiting as soon as market events take the odds out of your favor, you let probabilities work in your favor.

Notice that this is a major reframing of stop-losses. A stop loss level is not defined by how much you're willing to lose. Rather, it's defined as that point at which the odds cease to be in your favor. The poker player will draw a new card that adds nothing to the hand and folds shortly thereafter: the updating of probabilities tells him to stop. But if you don't know the probabilities to begin with, it's hard to hold positions until the benchmarks are hit, and it's difficult to know when and where to stop playing.

Every day in the market offers us a few hands to play. To win the tournament of trading, we play many, many hands. Consistency--knowing and following the odds--distinguishes the professional gambler from the guy feverishly feeding a slot machine. Perhaps it's not so different in markets.


Handicapping Odds in Trading