When we put on a trade, how much do we really know about the outcome in price change before the fact? Not much. Wise traders generally make allowance for greater errors than their lesser colleagues deem necessary, and they concentrate on getting out from in front of the train faster than most others. It's a skill we acquire from losing our own money. When we run, we run fast.
So incomplete information, due to lack of transparency of complex and opaque markets, causes unexpected errors which must be mitigated. Better research helps the odds, but the impact of errors on the traders’ portfolio always be reduced before the moment of impact.
There are other trading advantages, many of them outside the law. Most of these have been tried already, and for every action, counter reactions have been mostly concocted already by the other traders in the market.
When you really get down to it, there are only a few successful approaches to trading (not trading systems). Everybody works on assumption or hope of superior knowledge compared to the next guy. And some insiders really do have that in their specialized field. But across the market, and the economy, which are monstrous complex things, the best most have is a model created to provide a theoretical concept of how price will react to this or that change in input, or to put it another way a change in “conditions”.
So a trader is using research to find an asset selection system with the greatest edge possible, which works with a positive outcome as often as possible. But the trader must also regard every single individual trade as possibly being the one which breaks his research, and becomes the destructive exception to his researched tendency. Therefore every single trade is also managed as if it were a gamble, which it is. Only the group or total body of trades can be considered as following the statistical run of probability. Every next trade could be the speeding freight train coming towards a trader.
The law of averages applies to “trading” as a whole but never applies to any single trade. Therefore a system of risk management, or loss management must be used, for the purpose of prevention of terminal damage from the outlier trade or trades, whichever trade(s) it turns out to be.
Various gambling techniques have been found to try to deal with this.
Take the example of a coin toss. We know that the odds of a head or a tail toss are 50% with respect to each other. Therefore it is logical and correct to assume that if one tosses a coin 100 times, the odds are that 50 : 50 heads : tails will be the result. So what if one comes along after several heads have been achieved. It seems reasonable to think that there must be a tail coming soon, indeed several tails would be required to correct the deviation from the average. Place your bet on tails for a return to the mean.... Wrong! Alas, if only things were that simple.
The coin itself has no intelligence, no mind, nor desires to conform to any expectation. Every time it’s tossed, that is a fresh contest with the 50:50 odds. And the last toss, or last 100 tosses matter not one whit. A knowledge of 10 heads tosses recently, is of no use for prediction of the next independent outcome. That is a gamble.
Now the law of large numbers does mean that when more and more tosses are done, the average results will approach the 50% mark, but that is only because the chances of a “run for heads” is reduced as more random events are added to the statistical total number of tosses. The run may occur, but it's a smaller sample of the all. The next one can still be either heads or tails.
This has profound implications for traders, who become masters at dodging unexpected freight trains so as to live for tomorrow, and enjoy more chances to keep on tossing their coin.
Let us look at some of the methods which have been devised to deal with this problem. If a trader has 100 units of capital, and risks 10 of them on every trade, then a loss takes capital down to 90 units. If his next trade is profitable, it must make 11 units to return to the beginning point. Losses must exceed profits. But 10 bad trades could wipe our theoretical trader completely.
So the better way might be to risk, not 10 units on a trade, but 10% of his capital on a trade. Now if a trade is a loss, 90 units remain, and the following trade risks 10% of that 90 units. The next trade loses (if it loses) only 9 units. That takes capital to 81 units. If a third consecutive trade makes a loss it will be 10% x 81 = 8.1 units. It is a lot harder to get wiped out trading this way. Increasing trade size after a win, and decreasing stake size after a loss is called Anti-Martingale Trading. The Anti-Martingale approach is a very good idea, and well evidenced by the common characteristics of successful traders.
Unfortunately if one is an anti-martingale, the winning trades have less capital riding, and they make a smaller profit. This makes it take longer to get even after a losing streak. It's much better to minimize losses before they get large because of this, and to expect/allow for a greater number of trades "to get back". Naturally our theoretical trader considers this matter to find out if there is a way around the difficulty of making a comeback.
Recouping by Doubling Up. What if our trader decided to increase trade sizes after losses instead of decreasing them? That way if he loses 10 units, then for his next trade he bets 20. If it wins he is back on breakeven right away. But if the second trade is a loss he has lost 10 + 20 = 30 units, so he bets 30+ units on the next trade. Double up and one win will make it all back.
This is called The Martingale System of gambling. Remember that coin which has no memory, no conscience, and no pity? Our trader will need to have access to a lot of money if the run for heads gets lengthy. Doubling up requires a lot of capital very quickly when things go bad. In a rare run, say of 6 or more consecutive heads tosses, which can definitely but rarely happen, the trader required the following capital:
I assume merely trying to recoup losses for this example. Martingales always add in a little extra to earn next years bonus!
Capital = 10 units, trade size = 1
1st Bet: risk 1 unit .... 1 loss
2nd bet : risk 2 units ... lose 2 (total losses = 3) (or win, go home, a good day!)
3rd Bet: risk 3 units ... lose 3 (total losses now = 6) (or win, go home, a good day!)
Borrow 2 more units capital
4th bet : risk 6 units ... lose 6 (total losses now at 12, original capital gone, 2 units owed) (or win, go home, a good day!)
Borrow 12 units capital
5th bet: risk 12 units ... lose 12 (total losses now = 24 more than double the original total capital.
Borrow 24 units ( = 2.4 x total capital officially accounted for ...)
We usually don’t get to the next trade because our trader has been identified as a rogue trader, and was sacked, arrested, and is no longer in a position to try rolling the dice again.
Unless .... what if the trader has access to unlimited capital, belonging to someone else, which he can access at will? Well, the obvious thing to do is to go for it, and get his job secured again! So he doubles up, again, and again ...... The amounts of money lost forms a logarithmic curve which is going vertical. The borrowing debt is exponential, all capital wiped out very early.
Remember Nick Leeson?
From Wikipedia: https://en.wikipedia.org/wiki/Nick_Leeson
Quote: In 1992, he was appointed general manager of a new operation in futures markets on the Singapore International Monetary Exchange (SIMEX). Barings had held a seat on SIMEX for some time, but did not activate it until Leeson was sent over. ...
From 1992, Leeson made unauthorized speculative trades that at first made large profits for Barings: £10 million, which accounted for 10% of Barings' annual income. He earned a bonus of £130,000 on his salary of £50,000 for that year.
However, his luck soon went sour and he used one of Barings' error accounts (accounts used to correct mistakes made in trading) to hide his losses. ... Leeson used this account to cover further bad trades. ...
By the end of 1992, the account's losses exceeded £2 million, which ballooned to £208 million by the end of 1994. ... The beginning of the end occurred on 16 January 1995, when Leeson placed a short straddle in the Singapore and Tokyo stock exchanges, essentially betting that the Japanese stock market would not move significantly overnight. ...
Leeson attempted to recoup his losses by making a series of increasingly risky new trades..., this time betting that the Nikkei Stock Average would make a rapid recovery. However, the recovery failed to materialize.
Leeson left a note reading "I'm Sorry" and fled Singapore on 23 February. Losses eventually reached £827 million (US$1.4 billion), twice the bank's available trading capital. After a failed bailout attempt, Barings was declared insolvent on 26 February. Unquote
As it happened, by a coincidence, I was in Baring’s London for a meeting with their prop traders that very day. After lunch I left just as people began running around in a frantic way. By the afternoon’s end their careers had taken a turn for the worse.
I’m thinking about the Greenspan interview above. Did he say “I’m sorry?” I need to play it again to check.
The trouble with the Martingale approach is that when a losing streak appears, and one always eventually will, and the bets get doubled, the sums begin to get enormous.
The Martingale works with high probability, almost certainty, provided the trader has an infinite amount of capital. He also requires enough time for the “make it back” and put the money back where it should be, before the auditors come looking. Until then, auditors are unwanted visitors. Really really REALLY unwanted. Disclosure has no place in this at all. Ability to avoid disclosure is a BIG enabling factor.
Unwanted auditing - like auditors at Fort Knox, I suppose. Maybe unwanted auditing like the Freedom of Information enquiry about the size of the Federal Reserve “unofficial loans” which were 17 Trillion bigger than previously mentioned. That FOIA would have ended up as the headline story below, and many like it:
Does this seem reminiscent of a Rogue Trader?
The Fed’s $ 16 Trillion Bailouts under-reported
All that “doubling up” done in secrecy, without knowledge of the auditors, obstruction of attempts for information and disclosure ... the whole thing sure has a lot of the same signature features.
I suppose that a central bank, knowing it can create money at will, will tend to regard the positive outcome of Martingale Trading as a certainty. (“Just print more, place the next bet, and then we win!"). But every trader in the world knows it is really a novice play engendered by hubris and a childlike innocence of reality. Every trader in the world is wondering how long the run for heads will last.
When required a central bank can always print more, for as long as they want. Or until confidence vanishes if that comes first. Then interest rates do funny things and they can’t print any more. The Greeks found that out.
Until then I’m glad that we have such brilliant strategists in charge of our central banks, currencies, bond markets, financial sectors, ... oh... everything I guess! Their intelligence, experience, urbane demeanor and sophistication is impressive. I love the cut of their suits for interviews which are inspiring. Any resemblance to Martingale traders is surely superficial, coincidental and totally unjustified. After all getting out of terminal financial danger is a skill we traders acquire from losing our own money. We learned that painful lesson early and will never forget it or repeat it. The central banks' PhDs are sure to know it too. Oh wait .... whose money are they trading with?
2014 to 2017 will be such an interesting time, don’t you think?