The Number One Job Of A Trader

Thank you for your replies to my question: What is the number one job of a trader?

Your answers tended to revolve around making money, managing risk, protecting capital and making positive risk-adjusted returns. Those are all good suggestions that make sense. I would add that in professional trading firms, acting in compliance with the law and regulations is an explicit focus as well.

I think the real answer is deeper. For me, the number one job of a trader is to be allowed to play the game again tomorrow.

Why? Because it is a probability game, and the only people who are right every time deserve to be in jail. Even when you have a good edge, the odds are that there will be reasonably long streaks when the dice simply do not land your way. It is important to develop an edge (a positive expectancy), but it is equally important to be in business long enough to capitalize on that edge.

Take the example of a weighted coin, where you win 2x your stake if it comes up heads, and lose your stake if it comes up tails. You have $100 to play with, and the game will be played multiple times. How much should you bet on each coin flip?

The answer is clearly not $0: this game has an edge (a positive expectancy), so you should be willing to play it. However, the answer is clearly not $100  either: there is a reasonable chance that you will lose on any given coin toss, and so you should not risk your entire stake on one flip.

Smarter people than me can work out the math of what the “optimal” bet size is for this game. In the real world, the game is murkier since you do not know what the odds are: you can only make educated guesses or rely on historical back testing. The important point is that you need to act so that you can play the game again. Betting too big so that you blow up before the positive expectancy can play out in your favor is a fatal mistake.

Acting in a way that stops you being able to play a positive expectancy game again means that you have failed as a trader. This covers everything from losing so much money that you blow up/get fired, breaking any laws or codes that get you banned, or sleeping with the boss’s wife: anything that stops you being allowed to play the game again tomorrow. It doesn’t matter how good your trade idea is, or how much money the trade is going to make next week, or how good your average win/average loss ratio is: your swipey badge thingy has to open the door to the trading floor tomorrow.

You need an edge to make money over time. But if you have an edge, and you act in such a way that you cannot exploit that edge, you have failed.

Getting Rich Should Be Easy In A Country Where 39m People Go To Vegas

An understanding of Expectancy is at the heart of successful trading. Trading is a probabilistic game, and outcomes are expressed in terms of probabilities, not certainties.

Many amateur traders focus on one metric: the win/loss ratio or the Win Percentage. People like winning, and so having a high Win % feels good. It syncs nicely with other walks of life, such as sport: if your team wins more games than it loses the team tends to do well.

Unfortunately, the sporting analogy quickly breaks down. In sports, it does not often matter how much you win by: winning by a field goal or eight touchdowns still puts a “W” in the column. In trading, it very much matters how much you win by.

Imagine a trading system that produces ten trades. You win $100 on eight trades. But you lose $500 on two trades. Your Win Percentage is 80%, but you have lost $200 across all ten trades.

The Average Win/Average Loss ratio is just as important as the Win/Loss ratio.

Expectancy = (Win % x Average Win) – (Loss % x Average Loss)

or, in our example:

Expectancy   = (80% x $100) – (20% x $500)

= $80 – $100

= -$20

This trading system has negative expectancy. That does not mean it will always lose money: trading is a probabilistic game, and there is a reasonable chance of a string of winning trades. But in the long run, the system will lose money.

With a positive expectancy, the longer you play the more you win. With a negative expectancy, the longer you play the more you lose.

Which brings us to Vegas. Last year, nearly 39m people visited Las Vegas, of which 77% gambled. Almost everything in Vegas is a negative expectancy game for the public and a positive expectancy game for the casinos. The casino might not win each play, but the odds are in their favor. That is why casinos try so hard to keep you playing as long as possible. They even like it when you win, since that encourages you to play longer. They know they will win in long run.

In trading, it is important to develop a mentality or technique that puts you in the position of the casino, not the public. You do that by identifying and creating situations that have positive expectancy. You will not win every time. You may even lose the majority of the time: you can lose on 60% of your trades and still make money overall if your average winning trade is at least 50% larger than your average losing trade.

It appears that most people do not think about expectancy very much: the 39m people who gambled in Vegas last year to start with. Traditional fundamental analysis primarily deals projections and forecasts and very little with Expectancy. As Warren Buffett realized on his honeymoon, getting rich should not be a problem when plenty of rich, well-dressed people participate in games where the odds are against them.