INVESTING, TRADING, AND GAMBLING

INVESTING, TRADING, AND GAMBLING




Day trading isn’t investing, nor is it gambling — at least not if done right. But the lines between the three can be thin, and if you know where they are, you’ll be in a better position to follow your trading strategy and make more money. And if you can avoid the trap of gambling, you’ll be better able to preserve your trading capital.

The difference between investing and gambling is the risk and return tradeoff. In investing, the odds are generally in your favor, but that doesn’t mean you’re going to make money. Some day traders end up gambling, and then the odds are moving against them. And unlike in the finer establishments in Las Vegas, no one is going to bring the failed day trader free drinks to help ease the pain. A lot comes down to personality; if you are on a casino’s “do not admit” list, you probably aren’t a great candidate for day trading.

This starts off with a lot of gory details about risk and return. It helps you understand how the securities markets price risk and reward those who willing to take it. Then I explain the differences in risk and reward for investors, traders, and gamblers to give you better information to help you plan your day trading.

Understanding Risk and Return

Investors, traders, and gamblers have this in common: They are putting some of their money at risk and they expect to get a return. Ideally, that return comes in the form of cold, hard cash — but at a casino, you might get your return in the form of tickets to a Celine Dion concert after you lose a lot of money at the tables.

Trading is a business: The more you know about the potential risks and the sources of your potential return, the better off you’ll be. Your risk is that you won’t get the return you expect, and your reward is that you get fair compensation for the risk you take.

What is risk, anyway?

Risk is the measurable likelihood of loss. The riskier something is, the more frequently a loss will occur, and the larger that loss is likely to be. Playing in traffic is riskier than driving in traffic, and skydiving is riskier than gardening. This doesn’t mean that you can’t have losses in a low-risk activity or big gains in a high-risk one. It just means that with the low-risk game, losses are less likely to happen, and those that do are likely to be small.

What’s the difference between risk and uncertainty? Risk involves the known likelihood of something good or bad happening so that it can be priced. What’s the likelihood of your living to be 100? Or of getting into a car accident tonight? Your insurance company knows, and it figures your rates accordingly. What’s the likelihood of aliens from outer space arriving and taking over the Earth? Who knows! It could happen, but that event is uncertain, not risky — at least until it happens.

The ability to measure risk made modern business possible. Until mathematicians were able to use statistics to quantify human activities, people assumed that bad things were simply the result of bad luck or, worse, the wrath of the gods. But when they could understand probability, it could be applied and used. If a sailor agreed to join a voyage of exploration, what was the probability that he would return home alive? And what would be fair compensation to him for that risk? What was the probability of a silo of grain going up in flames? And how much should the farmer charge the grain buyers for the risk that he was taking, and how much should someone else charge to insure the farmer against that fire?

Considering the probability of a loss

Whenever you take risk, you take on the probability of loss. If you know what that probability is, you can determine whether the terms you are being offered are fair and you have a reasonable expectation for the size of the loss.

Let’s say that you are presented with this opportunity: You put up $10. You have an 80-percent chance of getting back $11 and a 20-percent chance of losing everything. Should you take it? To find out, you multiply the expected return by the likelihood and add them together: (80% × $11) + (20% × $0) = $8.80. Your expected return of $8.80 is less than the $10 cost of this contract, so you should pass on it.

Now, suppose you are offered this opportunity: You put up $10. You have a 90-percent chance of getting back $11 and a 10-percent chance of getting back $6. Your expected return is (90% × $11) + (10% × $6) = $10.50. This contract would be in your favor, so you should take it.

Now here’s a third proposition: You put up $10. You have a 90-percent chance of getting back $13.89 and a 10-percent chance of losing $20 — even more than you put up. Your expected return is (90% × 13.89) + (10% × –$20) = $10.50. It’s the same expected return as the proposition above, but do you like it as much?

When thinking about loss, most people tend to put too much weight on the absolute dollar amount that they can lose, rather than thinking about the likelihood. The problem is that the markets don’t trade on your personal preferences. This is one of the psychological hurdles of trading that those who are successful can overcome.

Working with limited liability (usually)

Securities markets rely on the concept of limited liability. That is, you cannot lose any more money than you invested in the first place. If you buy a stock, it can go down to zero, but it can’t go any lower. If the company goes bankrupt, no one can come to you and ask you to cover the bills. On the otherhand, the most the stock can go up in price is infinity, so the possible return for your risk is huge. (Microsoft has grown more than 500-fold since it came public, which isn’t quite infinity, but I sure wish I had taken that proposition.)

Most day trading strategies have the same limited liability: You can lose what you trade, and no more. Some strategies have unlimited liability, however. If you sell a stock short (borrow shares and then sell them in hopes that the stock goes down in price, allowing you to repay the loan with cheaper shares, and if the stock goes up to infinity, you have to repay the loan with those infinitely valued shares! Most likely, you’re going to close out your position before that happens, but keep in mind that even if you close out your positions every night like a good day trader should, some strategies have the potential to cost you more money than you have in your trading account.

To protect themselves and to protect you against losing more money than you have, brokerage firms and options exchanges will require you to keep enough funds in your account to cover shortfalls. You will have to be approved before you can trade in certain securities. For example, anyone trading options has to fill out an agreement that the brokerage firm must first approve and then keep on file.

Playing the zero-sum game

Many day trading strategies are zero-sum games, meaning that for every winner on a trade, there is a loser. This is especially true in options markets. Now, the person on the other side of the trade might not mind being a loser; she may have entered into a trade to hedge (protect against a decline in) another investment and is happy to have a small loss instead of a much larger one.

The problem for you as a day trader is that there is little wiggle room in a zero-sum game. Every trade you make is going to win or lose, and your losses may exactly offset your winners. If your strategy takes place in a market that is a zero-sum game, such as the options market, make sure that you’ve tested your strategy thoroughly so that you know whether your odds are better than even.

Finding the probability of not getting the return you expect

In addition to absolute measures of risk and liability, there’s another consideration: volatility. That’s how much a security’s price might go up or down in a given time period.

The math for measuring volatility is based on standard deviation. A standard deviation calculation starts with the average return over a given time period. This is the expected return — the return that, on average, you’ll get if you stick with your trading strategy. But any given week, month, or year, the return might be very different from what you expect. The more likely you are to get what you expect, the less risk you take in the form of volatility.

Standard deviation shows up many times in trading, and there’s a detailed explanation of it. The key thing to know is this: The higher the standard deviation of the underlying securities, the more risk you take with your trade. However, the same volatility creates trading opportunities for day traders to exploit. A security with a low standard deviation isn’t going to offer you many chances to make money over the course of a day.

Standard deviation is used to calculate another statistic: beta. Beta tells you how risky a security is relative to the risk of the market itself. If you buy a stock with a beta of more than 1, then that stock is expected to go up in price by a larger percentage than the market when the market is up, and it’s expected to go down by a larger percentage than the market when the market is down.

High-beta stocks, and options on high-beta stocks, are riskier than low-beta stocks, but they offer a greater potential for return.

The word beta comes from the capital assets pricing model, an academic theory that says that the return on an investment is a function of the risk-free rate of return (discussed in the next section), the extra risk of investing in  the market as a whole, and then the volatility — beta — of the security relative to the market. Under the capital assets pricing model, there are no other sources of risk and return. Any other sources would be called alpha, but in theory, alpha doesn’t exist. Not everyone agrees with that, but the terms alpha and beta have stuck.

Getting rewarded for the risk you take

When you take risk, you expect to get a return. That’s fair enough, right? That return comes in a few different forms related to the risk taken. Although you might not really care how you get your return as long as you get it, thinking about the break-down of returns can help you think about your trading strategy and how it works for you.

Opportunity cost

The opportunity cost of your money is the return you could get doing something else. Is your choice day trading or staying at your current job? Your opportunity cost is your current salary and benefits. You’d give up that money if you quit to day trade. Is the opportunity cost low enough that it’s worth your while? It may be. Just because taking advantage of an opportunity carries a cost doesn’t mean that the opportunity isn’t worth it.

When you trade, you want to cover your opportunity cost. Your cost will be different than someone else’s, but if you know what it is up front, you’ll have a better idea of whether your return is worth your risk.

There’s another way to think about opportunity cost. When you make one trade, you give up the opportunity to use that money for another trade. That means you only want to trade if you know that the trade is going to work out, more likely than not. That’s why you need to plan your trades and backtest (run a simulation using your strategy and historic securities prices) and evaluate your performance so that you know that you are trading for the right reasons, and not just out of boredom.

Risk-free rate of return and the time value of money

The value of money changes over time. In most cases, this is because of inflation, which is the general increase in price levels in an economy. But it’s also because you give up the use of money for some period of time. That’s why any investment or trading opportunity should include compensation for the time value of your money.

In day trading, your return from time value is small, because you only hold positions for a short period of time and close them out overnight. Still, there’s some time component to the money you make. That smallest return is known as the risk-free rate of return. That’s what you demand for giving up the use of your money, even if you know with certainty that you’ll get your money back. In practice, investors think of the risk-free rate of return as the rate on U.S. government treasury bills, which are bonds that mature in less than one year. This rate is widely quoted in The Wall Street Journal and electronic price quote systems.

If you cannot generate a return that’s at least equal to the risk-free rate of return, you shouldn’t be trading.

Risk-return tradeoff

Economists say that there is no such thing as a free lunch. Whatever return you get, you get because you took some risk and gave up another opportunity for your time and money. In that sense, there is no secret to making money. It’s all about work and risk.

This is known as the risk-reward tradeoff. The greater the potential reward, the greater the amount of risk you’re expected to take, and thus the greater potential you have for loss. But if you understand the risks you are taking up front, you may well find that they are worth taking. That’s why you have to think about the risks and rewards up front.

The magic of market efficiency

The reason there’s a balance between risk and reward is that markets are reasonably efficient. This efficiency means that prices reflect all known information about the companies and the economy, and it means that all participants understand the relative tradeoffs available to them. Otherwise, you’d have opportunities to make a riskless profit, and that’s just won’t do according to the average economist. “You can’t pluck nickels out of thin air,” they like to say. In an efficient market, if there’s an opportunity to make money without risk, someone would have taken advantage of that already.

Here’s how it works: You have information that says that Company A is going to announce good earnings tomorrow, so you buy the stock. Your increased demand causes the price to go up, and pretty soon, the stock price is where it should be given that the company is doing well. The information advantage is rapidly eliminated. And in most cases, everyone gets the news — or hears the rumor — of the good earnings at the same time, so the price adjustment happens quickly.

Wouldn’t it be great if you could get the news of a good earnings report before everyone else, to make a quick trading profit? Yep. At least until the Feds show up and hauled you off to prison — talk about your opportunity costs. It is illegal to trade on material inside information (which would be information that is not generally known that would affect the price of the security). And yes, the Securities and Exchange Commission and the exchanges monitor trading to see whether trading patterns suggest illegal trading based on inside information, because they want all investors and traders to feel confident that the investment business is fair. Be very wary of tips that seem too good to be true.

Now, you’ll notice in the example that it was the activity of traders that caused the price of Company A stock to go up to reflect the expected good earnings report. The markets may be more or less efficient, but that doesn’t mean they work by magic. Price changes happen because people act on news, and those who act the fastest are day traders.

In economic terms, arbitrage is a riskless profit. A hard-core believer in academic theory would say that arbitrage opportunities don’t exist. In practice, though, they do. Here’s how it works: although Company A is expected to have a good earnings announcement tomorrow, you notice that the stock price has gone up faster than the price of a call option on Company A, even though premium should reflect the stock price. So, you sell Company A (borrowing shares and selling it short if you have to), and then use the proceeds to buy the option. When the option price goes up to reflect the stock price, you can sell it and lock in a riskless profit — at least, before your trading costs are considered.

Investing

Investing is the process of putting money at risk in order to get a return. It’s the raw material of capitalism. It’s the way that businesses get started, roads get built, and explorations get financed. It’s how our economy matches people who have too much money, at least during part of their lives, with people who need it in order to grow society’s capabilities.

Investing is heady stuff. And it’s very much focused on the long term. Good investors do a lot of research before committing their money, because they know that it will take a long time to see a payoff. That’s okay with them. Investors often invest in things that are out of favor, because they know that with time, others will recognize the value and respond in kind.

One of the best investors of all time is Warren Buffett, Chief Executive Officer of Berkshire Hathaway. His annual letters to shareholders offer great insight.

What’s the difference between investing and saving? When you save, you take no risk. Your compensation is low — it’s just enough to cover the time value of money. Generally, the return on savings equals inflation and no more. In fact, a lot of banks pay a lot less than the inflation rate on a federally insured savings account, meaning that you’re paying the bank to use your money.

In contrast to investing, day trading moves fast. Day traders react only to what’s on the screen. There’s no time to do research, and the market is always right when you are day trading. You don’t have two months or two years to wait for the fundamentals to work out and the rest of Wall Street to see how smart you were. You have today. And if you can’t live with that, you shouldn’t be day trading.

Trading

Trading is the act of buying and selling securities. All investors trade, because they need to buy and sell their investments. But to investors, trading is a rare transaction, and they get more value from finding a good opportunity, buying it cheap, and selling it at a much higher price sometime in the future. But traders are not investors.

Traders look to take advantage of short-term price discrepancies in the market. In general, they don’t take a lot of risk on each trade, so they don’t get a lot of return on each trade, either. Traders act quickly. They look at what the market is telling them and then respond. They know that many of their trades will not work out, but as long as more than half work, they’ll be okay. They don’t do a lot of in-depth research on the securities they trade, but they know the normal price and volume patterns well enough that they can recognize potential profit opportunities.

Trading keeps markets efficient, because it creates the short-term supply and demand that eliminates small price discrepancies. It also creates a lot of stress for traders, who must react in the here and now. Traders give up the luxury of time in exchange for a quick profit.

Speculation is related to trading, in that it often involves short-term transactions. Speculators take risks assuming a much greater return than might be expected, and a lot of what-ifs may have to be satisfied for the transaction to pay off. Many speculators hedge their risks with other securities, such as options or futures.

Gambling

A gambler puts up money in the hopes of a payoff if a random event occurs. The odds are always against the gambler and in favor of the house, but people like to gamble because they like to hope that if they hit it lucky, their return will be as large as their loss is likely.

Some gamblers believe that the odds can be beaten, but they are wrong. (Certain card games are more games of skill than gambling, assuming you can find a casino that will play under standard rules. Yeah, you can count cards when playing blackjack with your friends, but it’s a lot harder in a professionally run casino.) They get excited about the potential for a big win and get caught up in the glamour of the casino, and soon the odds go to work and drain away their stakes.

There is such a thing as a fair lottery, which takes place when the expected payoff is higher than the odds of playing. You won’t find it at most casinos, although sometimes the odds in a sports book or horse race favor the bettor, at least in the short term. A more common example takes place in lotteries when the jackpots roll over to astronomical amounts. For example, in March of 2007, the multi-state Mega Millions lottery had a jackpot of $370 million, but the odds of winning were 1 in 175 million. This means that a $1.00 ticket had an expected value of $2.11, making it a fair proposition.

Trading is not gambling, but traders who are not paying attention to their strategy and its performance can cross over into gambling. They can view the blips on their computer screen as a game. They can start making trades without any regard for the risk and return characteristics. They can start believing that how they do things affects the trade. And pretty soon, they are using the securities market as a giant casino, using trading techniques that have odds as bad as any slot machine.

Managing the Risks of Day Trading

Now that you know more about the risks, returns, and related activities of day trading, you can think more about how you’re going to run your day trading business. Before you flip through the book to find out how to get started, consider two more kinds for risk that you need to think about:
  •  Business risk
  •  Personal risk


Business risk

Business risk is the uncertainty of the timing of your cash flow. Not every month of trading is going to be great, but your bills will come due no matter what. You’ll have to pay for subscriptions while keeping the lights turned on and the computer connected to the Internet. Taxes come due four times a year, and keyboards hold a mysterious attraction for carbonated beverages, causing them to short out at the most inopportune times.

Regardless of what happens to your trading account, you need cash on hand to pay your bills or you’ll be out of business. The best way to protect yourself is to start out with a cash cushion just for covering your operating expenses. Keep it separate from your trading funds. Replenish it during good months.

Personal risk

The personal risk of trading is that it becomes an obsession that crowds out everything else in your life. Trading is a stressful business, and the difference between those who succeed and those who fail is psychological. And, in fact, the personal risk is so great that I devote an entire chapter to managing it.

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