Trade Like The House
Warren is in the house @WarrenBuffett
If you want to trade successfully for a long time you need to understand what business you are in. You are not in the I-know-the-market-better-than-anyone-else business. You are not in the I’ve-got-the-sweetest-pattern-recognition-algo business. You are not even in the economics-analysis business. When you decide to become a trader you enter the risk assumption business.
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And if you really want to succeed in the risk assumption business you need to study two key industries that really understand how this game works -- insurance companies and casinos.
If you really want to win you need to trade like the house.
The first thing you learn about both casinos and insurance companies is that their whole business model is not based on prediction, but probability. Trading is very much the same way. Markets are not predictable. If you haven’t learned that after several years of doing this you haven’t been paying attention. Markets, at best, are probabilistic. That means that given a certain set of circumstances the probability of one outcome is slightly better than its opposite. That is hardly a ringing endorsement of certitude.
In fact it is a description of a world in a state of constant uncertainty -- kind of like insurance or gaming. So how do those two industries that have to deal with myriad uncertainties every single day not only survive but thrive as some of the most profitable businesses in the world? Here are a couple of rules that both casino’s and insurance companie use to make sure that the odds in their favor.
1. Limit your bet size.
There is a reason why casinos limit their exposure on any one roll of dice, deal of hand or spin of the wheel. They are not stupid. They know that luck is always against them. At any given time some drunken, slobbering moron can amble up to a table and bet 10 million on a hand and win. Its also the same reason why insurance companies do not issue open-ended policies. Every policy that any underwriter issues is capitated. Every policy has a fixed risk face amount known ahead of time.
So if you are trading without a stop, you are an idiot. You have already violated the first rule of the risk assumption business and the best bet that you can make is that you won’t survive as a trader for much longer.
2.Spread your bets.
When an insurance company issues you a policy it couldn’t care less about you as an individual. You are simply just one bet out of thousands that they are right and you are wrong. Something horrid may happen you -- in which case they would have to pay out -but insurance companies know that over a million bets the law of large numbers is on their side and their cumlative bet will beat your individual bets and make them money.
When you trade you need to have the exact same dispassionate attitude as an insurance company. The two deadliest words in trading are love and hate. The moment you assume those emotions is the moment you have lost because you just made that one trade more important that your whole business.
It’s laughable to think that an insurance company or a casino would care about one single policy or one hand of poker or baccarat, but as traders we make that mistake all the time and it is the single greatest downfall in the business -- (see JP Morgan Whale, Long Term Capital, Nick Leeson and a score of other blowups throughout history)
The great thing about being the house is that you don’t even need a large edge. In roulette, the edge is just 51%-49% yet it brings in billions to Las Vegas and Macao.
So next time you are frustrated because you missed your target by half a pip, or got pulled into a trade over some stupid commentary from a monetary official that didn’t even understand what he was saying remember this -- IT DOESN”T F-ING MATTER.
If you follow the well established rules of the risk assumption business, if you trade like the house -- you will eventually put yourself in a position to win.