John Wheeler is a theoretical physicist with a talent for memorable communication. In the nineteen-sixties he came up with the term “black hole” to describe the phenomenon we now know as…….. a black hole.

On scientific laws he offered: “There is no law except the law that there is no law.”

More generally, for anyone chasing knowledge, he said: “In any field, find the strangest thing and then explore it.”

So, in stock trading – or speculation – what is the strangest thing?

Surely it must be the large number of people willing to be losers so that others might gain.

Ours is a zero (or negative) sum game. On every stock index, one half of all shares traded must, on average, be traded for a loss, relative to the movement of the index itself. When trading fees and costs are taken into account, it’s plain to see that compared with buying the index there’s a net average loss associated with trading.

The winners must be a minority. So why on earth would anyone want to start trading?

Funnily enough, an answer comes from another theoretical physicist – the iconoclastic Richard Feynman.

In Surely You’re Joking Mr. Feynman, a collection of anecdotes about his life, he talks about his times in Las Vegas. Feynman, like Jesse Livermore, was a womanizer. He knew gambling was a sucker’s game but he liked visiting Vegas for the female company.

Here’s what he had to say about a visit to a casino:

….and she said “See that man over there, walking across the lawn? That’s Nick the Greek. He’s a professional gambler.”

Now I knew damn well what all the odds were in Las Vegas, so I said, “How can he be a professional gambler?”

“I’ll call him over.”

Nick came over and she introduced us. “Marilyn tells me that you’re a professional gambler.”

“That’s correct.”

“Well, I’d like to know how it’s possible to make your living gambling, because at the table, the odds are 0.493.”

“You’re right,” he said, “and I’ll explain it to you. I don’t bet on the table, or things like that. I only bet when the odds are in my favor.”

“Huh? When are the odds ever in your favor?” I asked incredulously.

“It’s really quite easy,” he said. “I’m standing around a table, when some guy says, ‘It’s comin’ out nine! It’s gotta be a nine!’

The guy’s excited; he thinks it’s going to be a nine, and he wants to bet. Now I know the odds for all the numbers inside out, so I say to him, ‘I’ll bet you four to three it’s not a nine,’ and I win in the long run. I don’t bet on the table; instead, I bet with people around the table who have prejudices – superstitious ideas about lucky numbers.”

Nick continued: “Now that I’ve got a reputation, it’s even easier, because people will bet with me even when they know the odds aren’t very good, just to have the chance of telling the story, if they win, of how they beat Nick the Greek. So I really do make a living gambling, and it’s wonderful!”

So Nick the Greek was really an educated character. He was a very nice and engaging man. I thanked him for the explanation; now I understood it. I have to understand the world, you see.

So, what’s the moral I take from this story?

Given the sheer number of suckers who make their way to Las Vegas hoping to win, but deep down knowing they’ll lose, and the numbers who lose money trading, it has to be that more people have an instinct for gambling than have an instinct for winning. They also like to experience the thrill of the game – whether it’s chasing the big win on the one armed bandits or on the trading screen. They like to talk about their experiences – “I beat Nick the Greek” or “I made 30% on the breakout”. Occasionally they’ll be lucky and have a big victory they can brag about. Losses are often kept quiet.

In addition to and tied in with the gambling behavior is the “I’m better than he is” attitude often seen in car drivers. Survey after survey shows the vast majority of drivers believe their driving is above average. Clearly it’s impossible for the majority to be above average at anything. People are systematically overestimating their own ability.

The trouble with trading is that a lot of books actually tell beginning suckers that, by following the advice of the book, they will become better than average traders. This reinforces their in-built car-driving/I’m better than he is attitude. Only bitter experiences and, sometimes, large losses change that.

For me, the willingness of traders to repeatedly lose money was the strangest thing in trading. What do you think?

A couple of my recent articles have been about ‘gut feel‘.

I’m writing about gut feel for the last time today – about how our gut feel for numbers – probability/chance in particular – is inaccurate. This is important because trading is a game of chance. We should trade when we have the highest expectation of success.

Most of this post is taken up with the Monty Hall game. If you’re not already familiar with it, Monty Hall can be a surprising introduction to how we misjudge our chances of winning. I’ll begin, though, with a quick look at birthdays.

Gut Feel Misjudges Birthday Probabilities

How many people do you think would need to occupy a room for a 50/50 chance that two of them share the same birthday? The answer is 23.

For a 99%+ chance that two people share a birthday, only 57 people are needed.

These results are counterintuitive. Our gut feel is that more people should be needed.

Gut Feel Misjudges Chances of Winning a Game

Another well-known example of how our gut feel gets confused about probability is the Monty Hall Game – named after the host of the 1960s television quiz show Let’s Make a Deal.

Each week, Monty Hall would offer the contestant three doors. Behind one door was a big prize and behind the other two doors was nothing. Obviously, the contestant had a 1 in 3 chance of choosing the winning door.

Let’s imagine that you are a contestant.

You pick a door – the blue one – hoping to win the prize.

Then Monty has a bit of fun with you. Monty knows which door the prize lies behind. After you tell Monty your choice, he opens one of the doors to show you that the prize isn’t there.

Monty then asks you if you want to change your mind.

So what do you do? Stick with your first choice or change?

I’ll give you a moment to make your choice – try to choose without reading ahead.

Made your mind up? Good.

The correct answer is that you should accept Monty’s offer and change your selection to the yellow door. Doing so increases your chances of winning the prize.

Now, I must admit when I first heard this puzzle, my initial instinct was to stick with my original choice – I didn’t think it would make any difference switching doors. Surely, after Monty had shown me one empty door, I would have a 50/50 chance of winning the prize whether or not I switched my choice of doors. But, no, that’s not the case. In fact, after Monty has shown you one empty door, there’s a two-thirds likelihood that the prize lies behind the door you did not originally pick. Let’s see why.

First, you are presented with a choice.

You have a one in three chance of choosing the right door.

Second, you choose a door.

There is a one in three chance the prize is behind this door. There is a two in three chance that it lies behind another door.

Now Monty opens a door.

In doing so, he changes your chances, if only you realized it. There must still be a two in three chance that the prize lies behind one of the doors you haven’t chosen. You have now been shown which of these doors doesn’t have the prize behind it. This means that choosing the final door – the yellow door on the right – has a two-thirds chance of winning the prize.

Summing Up

If we rely on gut feel in activities involving probabilities we are likely to make big mistakes.

There’s a stock market saying that bulls can make money, bears can make money but the pigs get slaughtered. Make sure you leave gut feel to the pigs and write your trading plans using predefined, objective criteria.

I want to talk a little more about how conditioned minds can prosper in trading. You’ll be relieved to know that I’m going to use a trader rather than a scientist as the example this time.

Jim Leitner runs Falcon Management in New Jersey. He has taken $2 billion profit out of the market in his career. Jim gave an interview to Steven Drobny for his book The House of Money. Jim’s mind has been conditioned by a huge amount of experience in trading, as follows:

• While studying international finance and Russian at graduate school, Jim worked half days as a “monkey” – a money broker trainee adding data from around the world to the big board for the brokers to see.
• While still working as a monkey, he started broking – calling small banks in the Midwest. He did this for two years.
• He then took a big salary cut to get more experience, working at J.P. Morgan, trading the Eurodollar market. Jim became an expert on euroswiss francs, eurodeutsche marks and europesetas.
• He then became an FX trainee with J.P. Morgan and then a currency forward trader.
• After a few years, Jim was hired by the Bank of America to run forwards, exotics and all currency trading outside the major currencies.
• He moved to Shearson Lehman as a proprietary trader.
• He moved to Banker’s Trust and spent five years trading currencies.

With all this experience behind him, Jim was asked whether he has an innate trading skill and can “just tell” when prices are out of line. He answered:

“I don’t have an innate skill. It comes from being extremely interested in markets and looking at everything all the time. After doing it for years I’ve developed a mental database of where things should be, such that when something makes an irregular move, it shows up on my radar screen. I used to have so much fun playing around in the market and knowing that I knew my markets better than other people.”

So here again, is an example of a conditioned mind prospering where others fail. Where others might claim an innate skill or a gut feel for trading, Jim Leitner attributes his success to conditioning of the mind – a mental database – built up from many years’ trading.

Jim Leitner’s hedge fund, Falcon Management, has a website. You can find out their address and their phone number but nothing else.

I’m off now to condition my own mind.

I’ve heard experienced traders talk about trading on “gut feel”. Inexperienced traders need to be cautious about this sort of trading – if they don’t want to see their trading accounts clobbered.

What exactly is gut feel? I see it as the way our previous experiences have stacked up to guide our decision taking.

You’ll need to forgive me for bringing science in here, but scientists and traders have quite a few things in common – one of which is that we’re constantly trying to analyze data to construct the most accurate or financially beneficial models of our worlds. The astronomer James Christy’s discovery of Charon – Pluto’s moon – is a great example of using previous experiences to see the true picture.

After Christy discovered Charon he looked back at other people’s work and he realized that Charon had already appeared on many other images of Pluto – but people hadn’t seen it.

So why hadn’t the people who had analyzed the images before – and we’re talking about professional astronomers here – realized Pluto had a moon? It turns out that Pluto and Charon were closer together than anyone had ever expected a planet and its moon to be. The astronomers who had seen images of Pluto and its moon together had discarded them, believing the images were distorted because Pluto appeared to be “elongated”. The “elongation” was, of course, Charon.

The astronomers’ minds had been conditioned to interpret the images incorrectly. Here’s what Christy said about the discovery (from Planets Beyond by Mark Littman):

“When I first saw these exposures on June 22, 1978, I was looking with the mind and eyes of an astronomer who had examined roughly 50,000 images in recent years. Many of these images had been of double stars exposed in the course of the U.S. Naval Observatory’s extensive double-star program. I had seen dual images blended together in all possible circumstances by all combinations of image distortions. My mind was now attuned to two celestial bodies disguised as one. Now I could think: Pluto has a moon.”

Christy’s mind had been conditioned by years of experience to see the possibility that the elongation in images of Pluto was actually its moon.

In our day-to-day lives, our minds are conditioned and tuned – just as Christy’s was – on the basis of our previous experiences. When we use these accumulated experiences sub-consciously we call it gut feel.

The better the mind has been conditioned, the better the prospects of gut feel actions having a successful outcome.

When we’re trading, if our minds have been conditioned by years of observations and experiences during different phases of market behavior they can reach better conclusions than if they’re less experienced. The sort of gut feel that can sweep across stocks, commodity and FX markets and pick up more than its fair share of good trades doesn’t come quick and it doesn’t come cheap. It takes years of experience with plenty of costly mistakes along the way.

I recall a discussion I had around 5 years ago with a semi-sucker.

This particular semi-sucker had misunderstood a trading book. He believed it should be possible using money management techniques to beat the casino at roulette. Provided he could cut his losses (by leaving the casino when he was losing) and let his profits run (by continuing to play when he was winning) he was “bound to make money”.

Now, I know this gambling strategy sounds superficially similar to Livermore’s strategy of quickly closing losing trades and allowing winning trades to run: but there’s one crucial difference. Livermore’s strategy – through his tape reading and trend following – had positive mathematical expectation. ^*

The suckers who play roulette in casinos do so under the handicap of negative expectation. It’s the casino owners who enjoy positive expectation – why else would they be in the business? The direction of money flow is from a casino’s customers to its owners.

Money management can’t turn a game with negative expectation into one you can win – it can only keep you playing longer. All that our semi-sucker friend could hope to achieve was more nights at the casino. Eventually, the casino would take all of his money.

The same outcome awaits the sucker who begins trading when his mathematical expectation is negative. Unless he is lucky, money will flow from him to people who have better trading strategies than he does. If he wins through good luck, the more often he plays, the likelier it is that his luck will run out.

The good news is that some markets are more forgiving than others. Given the long-term uptrend of the major stock indices, it’s often possible to turn a profit on long stock trades, even if you have poorer than average trading skills. Your profit will, of course, be lower than if you had simply put your money into an index-fund. And, with below average skills/knowledge/strategy, you’re more likely to end up with a big loss than a small profit – especially if you trade frequently.

^* Mathematical Expectation: Your chances are 50/50 when you bet on the toss of a fair coin. If the coin is loaded, however, and it landed heads more often than tails, then betting on heads has positive expectation and betting on tails has negative expectation.

1. Market commentators say money’s going to be made by anyone who goes long volatility. You decide it’s time to:

2. Tomorrow is your birthday and you’re feeling good. To celebrate your birthday, you’re going to:

3. It’s vacation time. You’re on a tropical island and a street vendor offers you a bag of peanuts for 50c. You:

4. Selling short is inherently riskier than going long because:

5. The 3-6-3 rule is:

Check out what sort of trader you are on Spot the Sucker.