One of my best friends likes to play poker. He’s pretty good at the game and has a poker saying that he uses to describe many of life’s situations. He likes to say “When you show up at a poker game and you don’t know who the pigeon is, you’re the pigeon.” There is great wisdom in this saying. He recognizes that at times he is the pigeon while other times he isn’t. I borrowed his saying because it serves to illustrate the concept of trading.
Trading is described as a zero sum game as is poker. For someone to win at poker it must come at the expense of another player in the game or in the case of trading, at the expense of another trader. In zero sum games the most talented participant typically prevails and the winnings come at the expense of the least talented. The least talented according to my friend is the pigeon.
Lets look at a poker game with 5 friends that each show up with $10 to bet. The total capital in the game is $50 and the most that any one player can win is $40 and that only happens if he takes the $10 from each of the other players. No matter how the game ends what is clear is that the winner makes money from the loser. In trading it is the same thing. In order for a trader to win he must make a transaction. He must either buy something from someone or sell something to someone that either goes up or down. One of the two will be right and the other will be wrong. It is just that simple. The one that is right makes money from the one that is wrong.
Let’s get to the positive part of this tale. In the poker example amongst friends if everyone had equal talent over time they would all break even. But we know that people don’t have equal talent. Amongst this poker playing group the player with the most talent will eventually take all of the money from the other players. I describe this superior skill as a positive expectation. I like to think of it as the superior player having the advantage over the inferior player. The same holds true for trading. The superior trader will eventually take all the money from the inferior trader. In the case of zero sum games such as poker and trading, talent matters. You must have a positive mathematical expectation in order to win. You don’t have to be the most talented poker player in the world in order to win; similarly you don’t have to be the most talented trader in the world in order to win. You just have to be better than the people you are playing against.
How can we describe this positive expectation in a zero sum game? The best examples always come with coin tosses. Everyone loves coin tosses. The following game if you played it long enough would be a profitable game for you. If every time you flip a coin and heads comes up I give you $2 and every time that tails comes up you give me $1 you would play this all day. You are playing a game that has a Positive Mathematical Expectation or PME from your perspective. Of course from my perspective I am playing a game that has a Negative Mathematical Expectation or NME. This is A Positive Tale because it is clear that if you want to make money participating in zero sum games you should dedicate your time to endeavors that only have a PME.
As I have mentioned in other tales. I promised my grandmother that I would never gamble. She had no idea that every gambling game that is offered at any casino has a NME to the gambler. She just knew that gamblers lost money. I didn’t know it at the time I made my promise but I respected her opinion. Let me say with no confusion, if you go to a casino and gamble you are playing a game you can’t win. You are playing a game where you are the pigeon. The longer you play the likelihood of you losing all of your money is 100%. If you are looking to make money, don’t gamble; it’s a NME game. I won’t get into the details of the various games and why the odds are always stacked against the gambler. If you are curious there are a number of other resources that you can access to validate my recommendation against casino gambling.
I hear people say that they like to go to casinos as a form of entertainment. They say that they allocate X amount of dollars to the endeavor no different than if they were to allocate the same amount of dollars to a good meal or show. I understand that they are consuming entertainment with their money. I see nothing wrong with this, since the intention is not one of beating the casino at its game. In this case the person is choosing to be the pigeon and who am I to say how people should spend their money.
This brings us to a different matter, the matter of trading. We learned that trading, like poker or casino gambling is a zero sum game. So in order to win at the trading game you must have a superior talent. You must be the casino if you are to win at trading. You must be the predator and not the prey. This means that just like in the coin toss example your trading methodology must have a PME. If you don’t this means you by definition will have a NME. Since we know that a trader with a PME will eventually take all the money from a trader that has a NME I suggest you either don’t play the trading game or get very good at it.
Let me say one last point about games or trading approaches that have a PME. It is still possible to lose money playing these games if you bet too much money on any one coin toss or trade. This means that a PME is an absolute requirement to winning the trading game but that it doesn’t guarantee success. The other component to success is betting the appropriate amount. As an example of over-betting or poor money management using the coin toss example, suppose I gave you $100 to start the game and you could bet whatever you wanted on any toss. If heads comes up I pay you $2 for every dollar you bet but if tails comes up I win what you bet. This is a classic game where you have a PME. However, you can lose at this game. How? It’s obvious that if you bet 100% of your money and you are wrong that you lose 100% of your money. You go broke and thus lose the game. As in poker the amount that you bet is an integral component of your success.