In today’s post, I show you how to take a winning game and become a loser at it. How? Because it IS possible to set up one’s trading with an edge that’s hard to beat… unless you beat it yourself. “We have met the enemy,” Pogo says, “and he is us.”
Of course, I don’t want to show you how to lose money so that you go out and DO it… I’m showing you how it’s possible to lose money at a winning game in order to expose another flaw in most folk’s trading plan. And help you fix said flaw. Cool? Let’s get started!
In Part I, we looked at the formula for calculating expectancy:
E = [P x W] – [(1-P) x L]
Where:
E is ‘Expectancy’ or Expected Return per Play
P is Probability of winning, expressed as a fraction
W is Amount of a Win
L is Amount of a Loss
A trading coach named Ralph Vince did a remarkable experiment. He rounded up 40 Ph.D’s… ruling out those whose degrees were in probability and statistics. In other words, really really smart folks that didn’t fully understand the implications of the above equation. He gave them a winning game: an even money wager with a 60% probability of winning. They all had $1,000 in ‘virtual’ dollars to begin with, were given 100 trials in which to bet, and were given total latitude as to how much to wager. They were prescribed no system for sizing their bets….
Wanna be shocked? 95% of the Ph.D’s LOST money.
Only two out of the forty players were able to beat a very beatable game: 60% of the time, players would win on an even-money bet. But most of them still couldn’t make it work. Let’s plug in the numbers:
E = (.6 X $1) – (.4 X $1) or .20 cents for every dollar wagered. (Hey, didja get all that? It’s 60% probability of a win, only as a fraction: .6, TIMES a dollar, MINUS the probability of a loss times a dollar. SO for every dollar you bet, you can ‘expect’ that over time your winnings will equal .20 cents per dollar you bet.
So HOW did 38 out of 40 Ph.D’s LOSE at this game?
Well, hmm. What if you bet your whole $1,000 on the first trial, and lost. Sure, you would have a 60% chance of winning on the next try but there wouldn’t BE a next try… you’re broke.
What about being too conservative? If you only bet $1, and did it 100 times… that’s $100 wagered at a .20 cent expectancy. You’ll end up with around $20 bucks to add to your original $1000 bankroll (yawn), a .2% gain in a game that SHOULD have made you some serious bank.
What if you were too conservative at first, but then stepped up your play a little late in the game? Say you bet only $5 of your $1,000 for the first 90 trials? Then you could expect to be ahead by around $450 X .20 cents = $90 bucks. With $1090 in your stack and only 10 tries left you figure that it’s time to risk more. You bet $300 once, lose it, get discouraged because you are at $790. Now you bet a more conservative $100 for each of the remaining 9 tries. You win five times, lose three… so you’re at $990 with one try left. And that try has a 60% chance of winning, regardless of what you wager.
In the above scenario you made only ONE foolishly high wager, bet conservatively the rest of the time, and it still comes down to just one more roll of the dice to see whether you win or lose a very, VERY beatable game. Wow.
Yikes… this is the inevitable outcome of NOT running the numbers. When you size your bets without a system, and bet according to what you feel instead of what’s ideal… you will lose.
Let’s take the above scenario again and think it through: Wagering too MUCH can cause a problem for obvious reasons… because though probability is 60% for each trial, streaks of wins and losses WILL happen. It’s not unthinkable that you would get three winners or three losers in a row. So betting a third of one’s account would be exceedingly unwise.
Betting too LITTLE will result in failure as well, though that failure would not be a problem of losing but of not gaining what should be coming as a result of a disciplined trading plan.
This is why I say that SIZE MATTERS… because it does. Bet size, that is… called ‘position sizing’ by trading coach Van Tharp. Of all the different factors of a trading system, these two are most important: positive expectancy (quantifying probability and payout for a trading edge) and a solid money management strategy.
With an amount of only $1000 to trade with and a system like the one above with which to trade, how about a bet of $100, times 100? That would be a total amount of $10,000 wagered. 60 wins equals $6000 in, 40 losses equals $4000 out, for a total of $2000 earned from playing a bankroll of $1000. Of course, if one had ten losses in a row to begin, this bet sizing plan would not work. But the likelihood of that happening is quite low with a 60% chance of winning every time.
The trick is finding a system with that kind of positive expectancy, AND matching the bet sizing to it appropriately.
For the answer we’ve got to go to Bell laboratories in the 1950’s, to some very interesting gentlemen and the beginnings of what is now called game theory. In the next post we’ll talk about some great names in the world of finance, mathematics, and information. Some of these names you may have never heard… but they have shaped our world and a lot of what goes on behind the scenes.
Okay Traders! Post away… We’ve gotten a lot of attention from the “Google Slap” post but now things have settled down a bit. I’m anxious to hear from you.
Happy Trading,
Kurt
I'm Kurt Frankenberg, and I have discovered how to truly put the odds on the side on the individual investor.
I find your married put strategy interesting. Since the market is overall bearish right now, can we have a “married call” strategy? Short the stock and buy calls deep in the money? For example if I short AAPL today at 325 and buy the July 290 calls at 37.5 costing me .77 % (37.5-35/325) to insure my position? Am I thinking logically on this? Is there any risk other than dividends? Thank you Kurt!
Dan, I DO have a strategy for playing the RadioActive Profit Machine “upsdie down” but it isn’t a ‘married call’. If enough folks are interested (hey, let me know guys) I’ll post a few hints about that. There’s a chapter in The Blueprint that deals with this idea.
HT,
K
William Adams
Kurt,
I, for one, would be interested in your take on the idea of “married calls”. BTW which chapter in Blueprint treats this subject? Thanks in advance.
The chapter entitled, “Bulletproof from the Beginning” alludes to my “synthetic backwards RPM.” Write me at support@radioactivetrading.com if you are a Blueprint owner for further illumination.
HT,
K
I found a good article to read on Money Management and Position Sizing. Hopefully, this will add food for thought.
http://www.turtletrader.com/gibbons.pdf
For an RPM, it is the put option component that works as a guaranteed stop loss, and IM#4 can be applied to lock in accumulated profits.
Thanks James! It’s a good read. I hope everyone on the blog goes and grabs it.
HT,
K
James,
Thanks for a great read. Folks should remember, though, that there is a fundamental uncertainty in the assignment of a percentage value to the probability of winning or losing any given trade. Is this a variant of Heisenberg’s Uncertainty Principle? 😉
William,
Kurt weighing in, I know you addressed that last to James. I dunno… my wife gets a little skittish when I talk to her about dead cats 😎 Or is that Shroedinger? Either way, YES, there is uncertainty in the market. But just as the time value approaches zero absolutely every time… uncertainty approaches zero with the passage of time. That is, eventually even fate must show its hand. Delta, and probability, is one to one on expiration Friday because uncertainty goes down the tubes as time unfolds.
HT,
K
Kurt,
Here is another well known saying:
“Bulls and bears make money, but pigs get slaughtered”
http://www.barrypopik.com/index.php/new_york_city/entry/bulls_and_bears_make_money_but_pigs_get_slaughtered_wall_street_adage/
Quote:
“The hog is the man who tries to get rich quick. A mere 10 per cent or so will not satisfy him. He will always say, “I can’t make any money unless I buy stock on margin because I haven’t enough money to get anywhere.”
Consequently he buys too much and has to trade extensively on margin. Sooner or later he is caught and can not pay out. he suffers a large loss and another hog is slaughtered. ”
I will also add that it is possible to suffer from a long string of consecutive losses and get slaughtered that way, as well. With the logarithmic approach as you mentioned earlier, betsize would go down, in accordance with each failed bet. This is a good thing!
Although, I don’t think it would hurt to look at other possibilities, such as expectations not being aligned with current stock/market conditions such as direction, volatility, what the stock/market has done already, and in making sure that the worst possible thing that can happen doesn’t do much damage to existing capital. The other side of the coin is to have an expectation and then wait for a sufficient amount of time to allow the stock/market to move in accordance with or against that expectation, before taking any action at all. This can help with addressing the problem with overtrading that can result from having mixed expectations.
It also doesn’t hurt to withdraw from trading for a while to regroup and rethink current investment/trading strategies, from time to time, if one’s account has been suffering from a string of losses.
In the world of Radioactive Trading, FIST (Forced Ideal Sized Trades) does an outstanding job in addressing current volatility and logarithmic adjustments to bet size based on current account size. The Income Methods are also essential for proper risk management, as well.
Thanks again James! Well, the intent of The Blueprint was to help those folks that were getting hurt by other strategies and money management methods (or lack thereof). SO I’m glad to hear that it’s being useful in that regard.
The Income Methods were so named because they’re all about taking a credit… which is SEXY… but not necessarily limiting upside like some spreads and covered call ideas will do.
Thanks again for your posts.
HT,
K
How about this for figuring your optimum share size. Let’s say you only want the risk to equate to 1% of your portfolio. Lets also say the Married Put strategy for 100 shares and one contract has a 5% loss risk for $200. Next assume your total portfolio is $100,000 so all you want to risk is $1000 based on your desired risk of 1. Therefore, divided $1000 by $200 for a total share size of 500. What do you think Kurt?
Oops bad math. Please disregard.