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October 27, 2006

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Mideast Crisis, Volatility
and Gold


Futures Trading Summit: Nov. 15-16, 2006, Las Vegas

When Trading IS Like Gambling

Name: Chad Butler

Company: RJOFutures

Learn More About Today's Author
Years Trading: 16

Favorite Movie: Glengarry Glen Ross

When Trading IS Like Gambling

There are a great many traders out there that take offense to any suggestion that trading is in any way similar to gambling.  The conventional response is that trading involves calculated risks, study of fundamental and/or technical factors in the market, following trends, and generally has an outcome that, while unknown, is in some way quantifiable.  Alternatively, this response factors in that gambling, with the exception of poker, has a negative expectation (the house edge, or “vig”), cannot be charted or analyzed, and being a game of chance, cannot be quantified the way that trading can. 

But I am here to tell you that is wrong.

I have taught seminars on this topic and often the majority of the audience is of the mindset that I just described, that trading is in no way like gambling.  One of my very first clients, when I analogized a specific trading strategy in terms of a gambling approach, stated, “Oh, we don’t gamble.”

In trading, as well as in gambling, there are two groups of people – the pros and the amateurs.  In order to understand the point I am going to make, you need to understand that there are indeed people who make a living gambling.  Most people agree that there are professional card players who make their living from playing poker.  Those same people are skeptical that there are pros who make a living at “negative expectation” games such as craps or blackjack.  That is because these people making a living at blackjack are not the people you actually notice in a casino.  They are not the typical high-roller or loud person at the tables.  They generally fly under the radar, quietly grinding out a living and do not care to be noticed by anyone, especially the casino.  Believe me, they are out there, you just do not notice them.

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So there are two groups in trading and in gambling – the pros and the amateurs.  If you compare what it takes to make a living at gambling and at trading, you will find much more common ground than you might think.  If compare what it takes to be a loser in either of these two fields, the similarities are uncanny.

Let’s examine the techniques of John Patrick, author of over 15 books on gambling techniques.  His recommended approach covers four main areas:

  1. Bankroll
  2. Knowledge of the Game
  3. Money Management
  4. Discipline

Do any of those sound familiar to you?  Perhaps you’ve read something similar in the last book you picked up on trading.  Let me rephrase these slightly:

  1. Appropriate Capital
  2. Knowledge of the market
  3. Money Management
  4. Discipline

To further illustrate my point, let me put these points, what Patrick calls “The Big Four,” into an analogy.  In a craps game, the amateur comes to the table with $100.  He is trying to make $1000.  He has a strategy, or so he thinks.  But he lacks discipline to stick to it.  If he gets up a little bit, he starts deviating from that strategy and making more bets.  If he gets into a drawdown, he deviates from that strategy to try to get back to even.  He lacks every single point of “The Big Four.”

Now, the pro in this game probably bought in with $1000 trying to make $100.  He’s not looking to break the bank, just grind out a living.  Preservation of his bankroll is paramount to his strategy and he is so concerned with that single fact that he does not deviate one iota from his strategy.  His approach to the game is based on the knowledge of the odds of every single bet on the table.  Therefore, he applies this knowledge to a very well executed plan that includes what to do when he is winning and what to do when he is losing.  He does not deviate from this plan.

If we changed the before-mentioned analogy to traders, which side would you fall on, amateur or professional?  No one is taking note of your answers, so be honest with yourself.  If you do not meet the criteria of every aspect of a professional trader, you fall into the amateur camp.  I do not mean that as an insult, and you certainly shouldn’t feel badly if that is the case.  But you do need to do some soul searching and commit to working on the areas in which you lack.  No one area of the big four can be neglected.

So let’s examine the two extremes in trading.  The amateur comes to the market with a small account.  He is attracted by the large returns that can be achieved with the incredible leverage futures provide.  He likely does not truly have risk capital and the money he scraped together to trade with may be a large sum to him but small in relation to the market he is trading.  If the market moves against him, he panics and deviates from his strategy.  When things are going his way, he deviates again because he is winning.  He completely lacks the big four.

The professional, on the other hand, is adequately capitalized.  He is working with risk capital so he can trade with a clear head.  He takes losing trades in stride because he has a complete, well thought out plan based on his knowledge of the market.  Applying his money management techniques to his strategy, he is able to manage drawdowns and compound his winnings.  In all of this, his strategy is gospel and he had the discipline to not stray from his plan.

Are you beginning to see the correlations here between trading and gambling?  House edge or not, we are talking about two very similar zero sum games.  For every winner, there is a loser.  The losers provide the money that the winners take away.  The professionals win consistently because they follow the big four.  The amateurs, as much as they enjoy the game, will never become professionals unless they take a good, long look in the mirror and follow the big four.

So let’s review the big four:

  1. Bankroll or Capital
  2. Knowledge of the Game/Market
  3. Money Management
  4. Discipline

Look in the mirror and be honest with yourself.  Are you lacking in any of the big four areas? If so, then you know what you need to work on.  Any of these can be fixed, up to and including discipline.  If you have worked out the other aspects of the big four, you should have enough confidence in your overall approach to stick to it, ultimately improving your discipline.

In order to fully grasp the concepts we are discussing, I would encourage you to request the complete series “The Basics of Money Management.”  This is a discussion of money management techniques that put this topic in a whole new light. You will gain a better understanding of risk control, position size, and stop placement, to name a few.  I am also including "The Golden Rules of Trading" including guidelines that will help you discover some of the principals that professional traders inherently live by.  This combination of material should get you started on the road to developing a sound trading plan.

About Today's Author

Chad Butler is a Senior Market Strategist with RJOFutures, a division of R.J. O'Brien. His 16 years of market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs. Chad’s published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, Futures Magazine, and other trade publications.  He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

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