Poker and trading

They're the same, really. I've long thought that all aspiring traders should learn to play a few hands of poker before moving on to the big game in the markets. But lately, I've been thinking the reverse may also be true.

See, in games of uncertainty such as these, we strive to play the game of optimal odds. It's simple math. If I do something profitable often enough, I should end up ahead in the long run. The problem with this is, this basic principle is often ignored.

How often have you heard the phrase "I'll pick a better spot to go all-in. No point gambling on a coin flip"? This approach is well and good when you're in the "coinflip" as a 49-51 dog. Forgoing the opportunity to take the 1 percent edge when you're ahead is just wrong in a cash game.

A 1 percent edge. Know how hard card counters work to get that kind of edge? It dawned on me on the ride home today that I have done my friend, Mike, a great disfavor in the past by not correcting him on this error in thinking. There is no "better spot" to shove when you're ahead, no matter how small the edge. There are only "other spots".

But what has this got to do with trading? Well, to be absolutely honest, this is in part a rant on the chains that have bound my research for the past year. Poker and trading live is pretty much the same. But the difference in pace would really open the eyes of many who have engaged in one but not the other. My above point on minute edges is but one of the many small things poker players should notice, but don't.

My thoughts are a little jumbled now(it's 520am, US markets have just closed), so bear with me if this post is particularly hard to keep track of.

First off, I find that traders understand precious little of what risk is. Poker players tend to relate to it more(though, as with mike's example, they understand it, but at the same time...don't). What is risk? Some people think it's the probability of you blowing up(for the poker players, that means busting your bankroll). Others think it's the maximum amount of money you can lose for a specific trade(traders) or hand(poker players). Few understand that there's really no difference in the two schools of thought.

See, risk isn't something we measure and tag a unit behind. It's really a floating value. If the risk of you busting your bankroll is reduced, the risk VALUE of your current hand goes down as well. They're related. You'll still risk the same monetary value, say $25...but risking $25 from a bankroll of $300 is different than losing from one of $3000. It's this floating value of risk that has doomed many a fund in the recent months. The mathematicians understand you can't define risk in a quantitative way. That's why they developed the concept of variance. The business types however, control the purse strings...and they want a number. Numbers make them happy. Abstract equations remind them of the advanced math classes they failed until they discovered accounting math. It's easier to sleep at night when you KNOW the books tally. Profits always on one column and losses always on another. We like simple things. The problem? We're really just making up the numbers we fill in the risk column. They're a close approximation MOST of the time. But most of the time doesn't quite cut it. Not when the cost of an error is unbearable.

So what's so important about understanding what risk really is? After all, losing $25 is ALWAYS a bad thing. And here's where we jump to the other side of the story...the traders. First thing you'll pick up when you start learning to trade is the concept of drawdowns. Basically, drawdowns bad, winstreaks good. In poker, we call it a bad streak. The more astute(or pretentious) of us will identify it correctly as variance. As poker players, we understand drawdowns are a part of the game, and it should only affect money management...ie, we do not change our game just because there is a big drawdown. We just change our betting sizes.

And here is where the rant begins. I've always been limited by the "need" to reduce drawdowns. The mathematician in me screams everytime I'm told my backtesting of a strategy indicates a drawdown that was "too big". Well, in the firm's defence, it makes perfect sense....no client would feel comfortable watching a 100million account shrink to 60million in 3 months. But that really isn't how strategies should be developed. It's ironic in a way. The cardinal rule of trading is to avoid curve fitting. The second most important is avoiding huge drawdowns. It's not hard to see that the two rules conflict.

So why am I pulling poker players into this? It's simple. There's alot to be learned from the blindsides of both camps. Just in case the poker kakis are gloating over how much of a grasp of statistics they have over the professional traders, keep in mind my first example of mike folding his AK against QQ after everyone has limped in because "he can pick a better spot".

I'll probably be coming back to these blind spots for both parties in the near future. There's lots to be discussed on this topic.