A Single bet...A roll of the dice...a flip of a coin - I now realized that each bet you make in the Futures market really is nothing more than a random outcome.
In my early years of trading my mom would always scold me - "Stop betting on the stock market - It's gambling."...Picture the finger wagging and angry look with furrowed brow as you read that.
"You are gonna lose all your money betting on the market"... I used to waste my breath arguing her, but to no avail.
We all know parents don't listen, and now I have also learned that kid's don't listen either, as I have a few.
And when you think about it, you are kid, and you are also a parent (or will be one day) - this means you didn't listen then, and you wont listen now either...
But I am going to change all that - I'm going to convince you that my mom was right.
Trading is gambling in a sense. It is a game of chance. So in order to learn how to win in the trading game, you have to learn how to bet. You have to learn how to quantify risk.
In Chapter 2 I touched upon my two trading heros. We already discussed Livermore and his fatal flaws that sank him both professionally as well as personally. Now I want to introduce you to Victor Sperandeo - or Trader Vic. The concept of risk as well as Trading and odds is something he discusses in his Masterpiece "Trader Vic - Methods of a Wall St Master."
I am not pumping books here, but if I had to recommend one that would be most beneficial for you to read it would be this. In many respects his book provided the blueprint for the 3PC Learning Center, even though I didn't realize it at the time. To discuss mastery of the markets you have to touch upon not only trading setups and strategy, but you have to focus on psychology, risk management, and odds.
And so I will provide a quote from his book regarding risk, that fits perfectly into this chapter.
"But what is risk? When I started my career on Wall St in 1966, I knew a lot more about playing poker than about the markets, but I also knew there were many similarities. Both require skill and luck, but more skill than luck. Both require knowing how to manage money so that even if you lose a few hands, you'll still be around to play in the next one. And both involve exposure to the chance of losing money, which is the meaning of risk.
I was good at poker because I knew how to measure and manage risk in the game. Instead of focusing on the size of the pot - the value approach - I only stayed in when the odds where in my favor; my focus was on the risk involved if I stayed in the hand. Risk involves chance, and chance involves odds. Odds take 2 forms: either those set subjectively by a professional oddsmaker, or those that are measurable according to probabilities based on a statistical distribution of limited possibilities."
He then goes on to provide a poker example of drawing on a flush, and measuring your pot odds to determine if you should bet or not. So if there is $80 in the pot, and you have to bet $10 to stay in the hand, your Pot odds on making that incremental bet is 9-1 ($90 total pot/ the bet you must make to stay in). If you are drawing on a Flush and need 1 more heart to make that hand, you know your odds of pulling a heart are roughly 5-1. So with a risk of 5-1, and reward of 9-1, the Risk/Reward for the current round of betting is 1.8 to 1 in your favor - You make that bet all day long. To finish this thought I quote Trader Vic again.
"If you employ this kind of strategy consistently, you may lose individual hands. You may even have a bad run of luck now and then, but you will win much more money than you lose over the long haul. I don't consider this gambling. Gambling is taking a blind risk. Speculation is taking a risk when the odds are in your favor. That is the essential difference between gambling and speculation"
Unlike card or dice games where there is mathematical certainty of what given odds are based on a fixed number of possibilities, markets are random & chaotic in nature; mimicking the emotions of the humans behind the buy and sell buttons.
Therefore in the markets, when we talk of probabilities or odds, we are basing them on the statistical distribution of outcomes that have occurred - and then using this as our baseline of what to expect going forward.
Actuarial Tables
The definition of Actuarial tables is: A table that shows the probability of a person of a particular age and lifestyle dying. Statisticians calculate the remaining life expectancy for people at different ages and different states of health. Insurance companies utilize these tables to help price products by using mathematically and statistically based tables that show event probabilities such as death, sickness and disability. Computerized predictive modeling allow for calculation of a wide variety of circumstances and probable outcomes.
A Second Discovery
In addition to my discovery that the Random Walk Theory does hold sway over price movement over a significant sample of outcomes, I also realized how valuable a tool it was to have the baseline tables to understand how price has behaved historically. In order to test the efficacy of my 4down1up indicator, it was not enough to know how far prices were likely to advance over a given time horizon, but it was also critical to know how far they retreated. Further, that information alone was not meaningful without comparison to a baseline table of price behavior irrespective of a certain setup.
The probability table for Gold that illustrates the Random Walk Theory now provided me something even more important - An actuarial table of price! I now know how far prices are likely to advance or retreat on a average given day. We are able to break down these moves by percentile in order to understand what is a statistically probable move in either direction. When price moves are advanced or getting stretched we can chart them against our tables and ascertain how likely they are to continue. When we enter a trade, Long or short, we are aware of the 70th percentile moves, or how much of a adverse move we can expect upon entry - This would be considered a normal move, and any mental "stop" or hedging should take this normal movement into account.
I realized that if insurance companies can create these statistical probability tables to help them price risk, why can't we do so? Well we can, and here at 3PC we did. Every indicator that we have in the Alchymist Platform has a statistical analysis behind it, telling us how price has behaved in the past, as well as how that price behavior behaves relative to the baseline probability tables.
Now if we can do this, so can you. All you need is the data and a spreadsheet and you can use computing power to analyze price and any given setup you believe provides you an edge. But just to be clear, this doesn't mean you data mine to come up with some statistical anomaly that shows you a 95% winner - something like "If I go long the second Tuesday of every other month, and close out by the following Monday, I make 25points in the S+P."
No. We use historical data to give us insight into movement & duration so we understand the statistical distribution of risk. This helps us with risk mitigation and proper place betting.
Real World Example
Lets go back to our example of Gold. Using our probability table for 2006-2016, we know that over 20days, the 70th Percentile Up move from prior day close is 22.40, while the down move is -17.50. Therefore if our system triggers a buy today, I know based off of 2,769 days of data during that period that:
1) There is a 97% chance price will move against us over the next 20days.
2) That in 70% of those instances, the drawdown will be at least -17.50
Therefore, from a risk management perspective, just through normal course of business we should expect to eat a - $1,750 hit (17.50 * $100 per dollar move in gold) per future contract. Depending on the size of your chip stack, this may or may not be a acceptable risk to you, but at minimum, it is quantified and understood prior to placing a trade.
Another way that we can use our baseline tables is to help us fine tune an entry point. For example, we can check how far prices have advanced or declined over the past 20 days. Let's say that price rallied or broke sharply to the tune of a $100 move. We can now look at our table and see that this has put us in the 90th percentile of all 20day moves over 2,769 days. This is not a Trade trigger, but rather it highlights that statistically this move is very close to it's end. We watch diligently for a short term indicator that price will reverse and we can take that signal with confidence, knowing that it is 9-1 in our favor that price doesn't continue it's preceding direction.
Can you see the power behind having this data? If the richest, most powerful Insurance companies use this for modeling risk, then you should as well. Now you know. And now you have the statistical data at your fingertips to integrate into your own studies on risk measurement, which will become the backbone of your trading program.