Is Trading Gambling?

The gambling known as business looks with austere disfavor upon the business known as gambling. – Ambrose Bierce, The Devil’s Dictionary

If you ever want to troll a trading forum, just ask this simple question: is trading gambling?  Unless the forum moderators are on the ball you’re all but guaranteed an epic mess.  For some reason this question pushes everyone’s buttons, and that’s a shame because it’s a legitimate question and a complete answer sheds light on the nature of both trading and gambling.

Such discussions seem to always take on a certain rather childish tenor.  Gambling = bad.  Investment = good.  The next step in the argument usually depends on the author’s views on trading and speculation.  If the author is pro-trading, then you get trading = investment = good.  If anti-trading, you get trading = gambling = bad.  A perfect example of the later position can be seen in this USA today column.

Now, if you’ve been reading this blog from the beginning, you’d be right to suspect i’m not on board with either of those arguments.  They’re both wrong.  For starters, I don’t believe investment is good.  Speaking for myself personally, I’m anti-investment.  In my childish notation, investment = bad – at least in the current economic climate.  The second problem with both arguments is that they’re framed in the context of “trading” which is a very uninformative term since trades can be entered for many purposes – speculation, investment, hedging etc.  Failing to make that distinction just confuses the matter.  What we really ought to be discussing here is speculation.  That’s what the errant brother in the USA today article engaged in.  That’s what this site is about.  That’s what 99% of people are talking about when they say trading.  So the question we should be asking is:

Is financial speculation gambling?  And is that a good thing, or a bad thing?

Now we’re asking a better question.  And the first part of the question is sufficiently simple to be answered by our definition of speculation and the dictionary definition of gambling:

speculation: the act of buying something one does not otherwise want with the intent to sell it later at a higher price.  Alternately, selling something one does not wish to be rid of with the intent of buying it back at a lower price.

gambling: to stake or risk money, or anything of value, on something involving chance.

Now, that looks pretty clear to me – speculation is definitely staking money on the price of a security.  And the price of the security in question definitely involves chance, at least to some degree.  Certainly it involves an aspect of unpredictability.  So case closed: speculation is gambing.  On to the next post 😉

OK, back up.  That wasn’t very satisfying at all – the dictionary definition of gambling is so broad as to mean very little.    It calls Ambrose Bierce rather forcefully to mind, since nearly all financial activities would have to be considered gambling in dictionary terms.  Devil’s dictionary, real dictionary: what’s the difference?  Somehow we’ve still missed the heart of the matter, which I think lies with the public’s perception of gambling.  And that perception is that gambling = bad.  There’s plenty of support for this position: gambling addiction, organized crime involvement, biblical prohibitions.  But perhaps the strongest is a phrase burned into American culture: “the house always wins”.  In this case, “house” refers to the gambling establishment.  And clearly this must be true on average – in order to pay for the casinos, the neon, the slot machines and the free drinks and then keep some money as profit the house must on win more than they lose.   This sentiment unsurprisingly is echoed almost verbatim in the USA today column.  We’ll return to it in a second.

But first, there’s an interesting intersection in the history of 20th century gambling and 20th century finance.  The most influential gambling book of the century was “Beat the Dealer” written by Edward Thorp.  It laid out in mathematical terms how to play blackjack (at least as the game was played at the time) and consistently win.  Beat the Dealer represented the arrival of the quants on the gambling stage – an event not unlike the neo-Doncian invasion of the trading world.  The catalyst for the two events was the same: readily available computing power.  Now for the intersection: this was the same Edward Thorp who created the modern idea of the hedge fund and ran one of the most successful examples.  It’s not an exaggeration to say that today’s trading landscape of private funds and proprietary desks came into being as a result of Thorp’s efforts and example.  The father of modern trading and the father of modern gambling are the same man.  Hmm…

Now we return to perceptions about gambling, and can add a new element to the public knowledge: Tharp’s “card counting”.  Almost everyone knows that, by means of increasingly arcane mathematical methods I won’d describe here, it’s possible to consistently make money playing the game of blackjack.  Interestingly, seemingly rational people can hold this belief while also believing “the house always wins”.  Odd – perhaps the public is a little screwed up in the head on the topic of gambling?  A more rational belief is that the house always wins unless you are in command of this arcane technical knowledge that allows you to win.  Then the game is to the player’s advantage.  In other words, gambling = bad is true if you lack knowledge.  But it’s possible that gambling = good if you know what you’re doing.  Sort of like trading…

This public confusion is understandable.  The community of professional gamblers are not inclined to discuss in clear terms what it is they do or generally to trumpet their existence.  Tharp and his partners Claude Shannon (of information theory fame) and John Kelly (who this blog will have more to say about) may be the patron saints of mathematical gambling, but the lineage goes back far further than that.  As long as there have been gambling games, there have been men who study the game and develop knowledge that allows them to win. This has usually been a small fraternity – historically probably less than 1000 people in the US, perhaps similar numbers in Europe and Asia.  Their ranks temporarily boomed in the first years of the 21st century when televised and internet poker showered wealth on their small subculture, and have subsequently contracted again with the death of internet poker.

I can speak with some authority about professional gamblers because for a time I thought I would become one and dabbled in their world.  If need be I could make a living at the card tables of Las Vegas.  I speak the lingo, and am acquainted with many of the people.  Few if any are my friends – they are not as a whole likable people.  In fact, they share the stereotypical faults of traders – mysogeny (nearly all are men), cocaine use, cynicism, a willingness to bend the law.  The only difference is the social outcast nature of gamblers means those flaws are more frequently celebrated and less checked by social pressure.  You would not want your daughter to marry one, and I stopped pursuing professional gambling as a source of income lest I become like them.  But whatever their faults, successful professional gamblers uniformly have two things going for them.  The first is keen intelligence.   The second is a means of evaluating gambling opportunities which separateness them from the money losing saps filling the casinos.  In the gambling literature, this evaluation method goes under the term “expectation” and it’s a powerful idea far too often overlooked by traders.

Expectation is a simple mathematical process: multiply the probability of various results by the results themselves, and then sum those products.  If the sum is positive, you have a “positive expected value” bet (abreviated +EV by gamblers).  If it’s negative, that’s “negative expected value” (-EV).  An example:

Someone has offered to flip you a fair coin, pay you $1.50 if it comes up heads and charge you $1 if it comes up tails.  The expectation is 0.5 (probability of heads) * $1.50 (heads result) + 0.5 (probability of tails) * (-$1.00) (tails result) = $0.25

The meaning of expectation is simple: if I choose to take this gamble, how much richer (or poorer) will I be on average?  In this example, every time you take the gamble, you expect to become $0.25 richer on average.  This may seem like dirt simple math, and it is.  But it’s powerful.  All gambles with expectation less than zero should be avoided.  Gambles with positive expectations are in general worth taking, although there may be other factors influencing the decision.  But the real key is avoiding the -EV gambles.  Beyond that, professional gambling is reduced to a simple exercise in probability and statistics – the more accurately you can estimate the probabilities of various outcomes, the more accurately you’ll be able to decide what gambles to take.  That was Tharp’s contribution – he took blackjack, a game no one had been able to compute an accurate expectation for, and demonstrate it was mostly -EV.  But he also showed that the game swung to +EV when the deck was heavy in aces and tens, and depleted of the middle number cards (5,6,7 etc.).  From there, the playing technique was obvious – on normal hands bet very little money (the house won’t deal to you if you don’t bet something) and count cards.  When the stub of the deck is sufficiently biased towards aces and tens the the game became +EV, radically raise your bet.  His blackjack system was a microcosm of professional gambling as a whole.

The truth is, there’s no real difference between the computations used to determine if a trading method is +EV and those used for conventional gambles.  The back and forward tests of trading system system development are simply a statistical method of determining EV.  It’s the same process – I say this as someone with a membership card for both camps.  Winning trading is the same as winning gambling.  Losing trading is the same as losing gambling.  The venue is different, and the people are different, but the soul of the process is the same.  Don’t be afraid to tell people what you’re doing when you speculate is gambling, because it is.

speculation = gambling = good (if you know what you’re doing)

Oh, and Merry Christmas 😀

 

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One thought on “Is Trading Gambling?

  1. I found the professional-gambling world filled with some agreeable people. And many with whom I would not voluntarily associate. I suspect that the professional-investment world is very similar; lots of smart people and a lot of relatively arrogant, accidentally rich, room-temperature IQ types.

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