Place Your Bets
An examination of some simularities and differences between the markets and a casino.
There are many similarities between trading in the stock market and gambling at a casino. There is the excitement involved, and easy money to be won ........... or lost. Today I wanted to take a look at some of the similarities, and also some key differences. Even if you do not gamble in a casino, this is an article that will enlighten you with a perspective about trading.
There is one thing that many people do not think about. All of those fancy casinos are not built with money that the casinos lose, they are built with the money that the public loses gambling in the casinos. And a big part of this money is lost by the public due to human nature. People get caught up in the excitement, they feel that they have to be playing all of the time. They will make bets that have very little chance of winning, and they do not use a "stop", instead they continue to play, trying to win back what they have lost, until all of their money is gone. And when the person is on a roll, they get greedy and "press their luck". In many cases they wind up giving back the gains they won.
There are many people that trade the same way. They are impatient and will enter a position that has little chance of working out. They will stay in the position as it goes against them, and allow it to become a large loss. And when a position goes their way, they will either get out too soon and not realize the profits they could have earned, or they will stay in it too long and give back the gains.
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While there are many of the casino games that could be compared to trading, I chose to use Black Jack as it is a game that most people are probably familiar with. The object of the game is very simple, you want to get the cards dealt to you to total 21 or as close to 21 as possible without going over so you can beat the dealers hand. So let's play some Black Jack and see what happens. |
When we first walk up to the table and sit down, are we going to
bet everything on the very first hand?
Anyone that has visited a casino, or has any common sense at all would know that
the answer to that question is a resounding NO! You know quite well that
there will be hands that will be lost, and to place a large bet is a sure way
towards being sent home early with nothing but lent in your pockets. The
bet has to be small enough so you can ride out a few bad hands.
This same logic also applies to trading. You do not want
to enter positions that are so large that they will hurt you should it go
against you. In that game of Black Jack, it is mostly a double or nothing
proposition, you either win and double your money or lose and have nothing left
from that bet, unless you get the rare occurrence where you tie the dealer and
breakeven. With trading you have an advantage of being able to "stop
out" of a position and not let it become a total loss should it start to go
against you. These are simple money management fundamentals. A
simple rule of thumb is to not risk more than 5% of your trading capital in any
single trade. The easiest way to adjust for this is with the size of the
position. If your account has $10,000 in it, and you are buying stock,
this means you do not want to lose more than $500 on any one trade. If you
buy 100 shares of a stock, this gives you 5 points before you MUST stop out of
the position. If your stop is 2.50 away from the entry price, then you can
buy/short 200 shares of the stock.
Options are a little different because your risk is defined upon the entry of
the position. When you buy an option or buy a spread, your maximum risk is
what you paid for the position. If the option or spread costs $1.00, then
you can buy 5 contracts, and should it go completely against you and you don't
get out, the max loss is $500. This does not mean you will stay in the
position and allow it to go completely against you, you would still want to stop
out before that happens. When you sell premium (a spread) your risk is the
difference between the strikes sold minus the premium collected. So if you
sell a 5 point wide spread, and collect $2.50 in premium, your risk is $2.50, so
you could sell a 2 contract spread, and your max loss would be at $500.
Once again, you would not want to let it reach that maximum loss, you would want
to stop out once it is clear the position is going against you.
There is one simple question you need to ask when you enter a position. "If this goes against me, will the loss hurt?"
In the game of Black Jack you have to place your bet before you get to see your cards. This puts you at a disadvantage, if you get a bad hand to start with you are stuck with it. Imagine if you could see your first 2 cards before having to bet. This would put the odds on the players side of the table. If you get a 12-16 you could just pass and not take the hand, and not lose anything by having a little patience. If you start with a 19-21 you would then place a bet as the odds are more in your favor of winning. This is where trading is different from going to a casino and playing Black Jack. When you use charts in your trading, you are getting to "see the cards" before placing your bet (entering a position)!
We have a recent experience in the stock markets that make for a perfect example. We take a look at the daily chart of the SPX from Nov. 8, 2004.
On this chart we have an overbought rally that did take the price up to new
highs, where the price became extremely overbought, and the price was beginning
to stall at 1165. The algorithm that I use to generate this chart does differentiate
between normal overbought/oversold conditions, and when these conditions become
extreme. I did some research on the history of the past 5 years, and found
that the indexes do not become extremely overbought very often. And out of
these occasions, it was rare for the price to continue the upwards move.
If we were to use this chart to look for a new "long" position and
compare it to the game of Black Jack, it would be like seeing our first 2 cards
total to 16, one of the worst hands you can get, especially if the dealer is
sitting with a ten showing. The odds of playing out this hand and being
successful are very slim, which tells us that a new "long" position at
that time would not present too much risk for the possible reward.
This particular chart is showing that the upwards move is very over extended,
but at this time it is not showing an indication to enter a short position.
We can fast forward to Nov. 18th, and we will see that after a pause at 1165, the price did defy the odds and moved higher.
This does not reflect badly on the charts, there are times when a "long shot" will pay off. It is up to you to decide if you are going to gamble with your money to chase after all of those long shots, or if you have the patience to stand aside and wait until you are dealt a high hand before placing your bet.
On Mon. Nov. 15th I made the following comments about the indexes.
"This gives us a very strong hint as to what the indexes will be doing in
the future, which will be stalling, which allows us to develop a trading plan of
selling call spreads with some expectations that the markets will not be setting
new highs. We will use the different time frames to know when the
risk/reward is the most favorable and when the upwards move has stalled."
The next day the candle turned yellow and the trend turned neutral, adding to
the indications that the upwards move was stalling.
By exercising some patience, and examining the different types of positions, the
following expectations were created. First we had the expectations that
the price was setting the highs, and that for a period of time would remain
below them. When we examine the different types of positions, the best way
to take advantage of this is by selling a call spread. By being patient we
were able to wait for cards to be dealt to us that showed we were sitting on a
"19". There was still some risk involved, and some issues on the
other time frames that kept this from being a 21, but it was still a high hand,
one that presented a favorable risk/reward situation..
As the days go by, the expectations from the 15th are holding up, showing that the trade of selling a call spread is working so far. We still want to use a stop, should the price break thru 1190 it would be showing that an upwards would be starting. There is one other thing that we have on this chart. We have a progression or red candles that show a downwards potential, and we have the trend turning red, which also shows a downwards potential. This would suggest that we are starting to see a hand being dealt that shows a downwards move could begin. We would want to use the full Time Frame Analysis to examine the other time frames, and then we could make a determination as to just how high of a hand is being dealt to us. This would give us the risk/reward situation along with a trading plan, and we could determine what we need to see to know when to "place our bet" (enter a position).
There is a risk of losing when you gamble at a casino, and there is a risk of losing when you trade. There will be times when you get dealt a "20" but the dealer will wind up with 21. The glaring difference is that when we use the Time Frame charts and get the perspective from both the longer and shorter term charts, we have a very distinct advantage in trading. We can see the hand that is being dealt before we make a "bet" by entering a position. We need to continuously ask ourselves 2 questions. "Is this a hand one that I can win with, or would it be better to skip it and wait for the next hand?" If it is a high hand that shows the odds are in your favor, then comes the second question, "If this turns into a loss, will it hurt me?"
When you use these 2 questions the trades that you place will have better prospects of working out, and you will be using good money management techniques that will result in better results for your trading account.
Jim. www.TimeFrameInvestor.com
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