Trading vs Gambling

High Rollers: Trading vs Gambling

A few months back I had the idea to teach my 2 daughters an important lesson regarding gambling. I asked them both if they wanted to learn how to play poker and both were very excited to try it out. However, I asked them to bring their piggy banks because my intention was for them to bet with real money. At the beginning they were intrigued by the idea of winning big with little effort and a bit of luck. So, I started to teach them the basic rules of the game, showing them each of the cards for them to memorize the difference between hands. We did a few hands and I was explaining to them who was winning etc.

Then I ask them if they were ready to start playing for real and start betting with their hard earned cash which both agreed and accepted.

The stars aligned and in the first real game, both of them lost their stake in the game. My youngest daughter did not fully understand what was happening; she just saw herself parting ways with her cash and watching me collecting it :D. Then, she started crying and she stopped playing. The older one decided to give it another try, and so, we proceeded with another hand. However, once again I got a better hand than her. Suddenly she realized that she also had lost her second game. She bursted into tears and decided she did not want to play either. I asked why, she said that she did not want to lose anymore money gambling.

I think there’s a fallacy when we approach the stock market. We start trading without truly understanding what is going on. Gambling is defined as the activity or practice of playing at a game of chance for money or other stakes. However, when trading is considered, gambling takes on a much more complex dynamic than the definition. Many stock market traders are gambling without even realizing it. In this blog post I will discuss how to avoid a blind bet and fall into gambling.

So continue reading …

One day, during lunch, I was debating with my co-workers whether or not the stock market would be considered gambling. There were people that agreed and others that disagreed strongly. However, from the arguments I couldn’t agree 100% for either party. In my personal opinion, I have always seen the stock market as an economics game, and if you see it as a game, the definition of gambling it is very close to trading in the stock market: “practice of playing at a game for a change of making money”. After some research I came to the conclusion that the stock market its an infinite game vs poker which is a finite game. However, if you are trading without analyzing and understanding without any system or using data through statistics, you are gambling, probably it would be more fun just to go to Las Vegas instead of doing YOLO on GME. 🤑

I want to divide the lesson for today in the following two points:

1. Learn the rules of the game
2. Measure the possibility probability of success

1. Learn the rules of the game:

The stock market is a complex ecosystem that has lots of numbers and history data but let’s start with some basic concepts. I got the following data from this link http://www.ehow.com/about_6586672_difference-between-stocks_-bonds-commodities.html If you know some of the following definitions you can skip and move on to the “Take a way #1” .

Stocks:

The New York Stock Exchange defines a stock as “an ownership interest in a corporation.” Also known as capital stock, shares or equities, stocks are the individual pieces of a company that are issued in return for money, used to fund corporate growth and investment. Stock prices reflect the buy or sale price of stocks at a given moment. For example, if GE stock is priced at $17.50, it means you can acquire one share of GE at that price. Other classes of stocks include preferred stocks, which pay a fixed dividend, or restricted stocks, which have special trading conditions.

Bonds:

Also known as notes or debentures, are a debt promise, issued by a company or government. Bonds are secured against the assets of the issuer, with a guaranteed rate of return. Bonds are not shares in the issuer and convey no ownership. They furnish a means for companies and governments to raise money and are traded openly on the markets. Bonds have maturities in three categories, short (less than a year), medium (1 to 10 years) and long (over 10 years). Government bonds are also known as Treasuries or T-bills and are regarded as the safest of all investments.

Commodities:

Commodities are physical tradable goods listed on the stock market. Common commodities traded are metals, such as gold, silver and copper, agricultural products, such as corn, coffee and soybeans, and industrial commodities like oil and gas. Special exchanges exist to facilitate trading commodities. Great attention is paid to certain economically and politically sensitive commodities like oil and gold. Because oil in particular is widely used in many petroleum products, gasoline and plastics, changes to the oil price can have wide economic consequences.

ETF:

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index.

Pay attention to the last one, because you might not know these financial instruments existed. I will write more in detail in the next posts using ETFs for trading.

The following video, though a bit long (I never said this was easy amigo), does a great job of giving you the big macroeconomics picture.

How does the economy really work? This simple but not simplistic video by Ray Dalio, Founder of Bridgewater Associates, shows the basic driving forces behind the economy, and explains why economic cycles occur by breaking down concepts such as credit, interest rates, leveraging and deleveraging.

https://www.youtube.com/watch?v=PHe0bXAIuk0

Take a way #1

Before you buy an instrument you need to understand the rules of the game weather you are buying stocks, bonds, ETFs, commodities or any other investment or a combination of them. That is if you are planning to Invest, trade or just pure gambling with stocks.

2. Measure the probability of success:

If you have been following my posts you may have noticed that I have tried to make the blog very simplistic in terms of knowledge. We need to start elevating the concepts just a bit, but don’t worry this is not rocket science you will get it easily.

To understand probability let’s start with a simple example. Everybody knows that if you toss a coin in the air there is a 50:50 percent chance of getting heads or tails. So, if you were betting you have a 50% chance of winning. In my opinion, I would like to see a higher probability of success to minimize the RISK. What if I told you that some brilliant guys from Harvard did this experiment and after millions of repetitions of tossing coins they came to the conclusion that heads have a little bit more chance of success. I don’t know but I always will try to go with higher odds. Let’s do some statistics calculations for the probability and learn some terms.

This chart represents probability distributions. It displays how the probabilities of certain events occurring are distributed. If we can formulate a probability distribution, we can estimate the likelihood of a particular event occurring (e.g. probability of precisely 47 tails from 100 coin tosses experiment is 0.0666 Probability. Noticed that sometimes the probabilities are used with decimals instead of percentages.

Let’s put this all into perspective. All I am talking about here is considering 100 coin tosses. The challenge is how we can calculate this for our stock market strategies. We will see that in the next posts I promise…

Probability Distributions

If I plotted charts for 1,000 or 10,000 coin tosses similar to the above, I would generate similarly shaped distributions. This classic distribution which only allows for two outcomes is known as the Binomial distribution and is regularly used in probabilistic analysis. The 100 coin toss chart shows that the average (or ‘expected ‘or ‘mean‘) number of heads here is 50. This can be calculated using a weighted average in the usual way. The ‘spread’ of heads is clearly quite narrow (tapering off very sharply at less than 40 heads or greater than 60). This spread is measured by statisticians using a measure called standard deviation which is defined as the square root of the average value of the square of the difference between each possible outcome and the mean. This is important to understand to see how far a stock price is from its mean. If you love math you will appreciate this if not don’t worry excel can do it very easily hehe.

Standard Deviation Formula

where:

σ = standard deviation

N = total number of possible outcomes

Σ = summation

μ = mean or average

xi = each outcome event (from first x1 to last xN)

You should be proud because now, whenever you see this type of chart, you can now identify it as a Generic Normal Distribution, or as you may have heard it called: “The Bell Curve”. Later, when we learn about stock options, we will use the bell curve on a regular basis. Please, don’t be intimidated by the formula because we will be using the system “Think or Swim” from TDAmeritrade or Interactive Brokers software, which will calculate the standard deviation for you, Mean etc.

Take a way #2

All this mumbo jumbo statistical and math stuff is to illustrate that we need to analyze and understand our data. As I stated in the beginning, if we analyze and understand our data through statistics, we are not gambling when we bet on the stock market game.

Peace

-Erick