Where gambling meets trading

August 15, 2015 09:00 AM


The debate about whether “trading” is a high-class sobriquet for “gambling” is not a mere parlor game. It has real-world consequences.

For if trading is really gambling (as some in Washington have proclaimed since the financial crisis), then perhaps gaming authorities should regulate stock markets instead of the Securities and Exchange Commission. Perhaps all the gains of investment managers should be taxed as gambling profits instead of capital gains. 

And, on the psychological front, investors would need to rethink their own appearances; right now, investing carries the imprimatur of logic, foresight, measured reason and prudence; whereas gambling has negative connotations of illegality, recklessness and desperation. 

Many in the financial community feel degraded by the gambler label. Yes, they wear suits, have ornate offices and trade massive amounts of money on exchanges.

But what, precisely, is the elemental particle that distinguishes trading, or its more respected “investing” activity from professional gamblers?

In many ways, advanced quantitative skills translate between the two disciplines. Advancements in technology have expanded the scope and scale of the investment and gaming opportunities for traders and gamblers alike. But fundamental differences, social stigmas and gray areas exist, making the topic somewhat taboo for many traders, politicians and social commentators.

In this year’s inaugural gaming and gambling issue, traders, economists, academics and hedge fund managers sound off on the elephant in the room — the ongoing convergence between investing and gaming — and explore the intricate differences and similarities that unite the worlds of these two disciplines.


Changing a gamble into an Investment

Gambling and investment practices are not so far removed from one another. 

There is a fine line between the public’s and the law’s distinction between investing and legalized gambling. Stocks and bonds, bank accounts and real estate are traditional investments. Poker, blackjack, lotteries and horseracing are popular games. Gold, commodity and financial futures and stock and index options are somewhat in between in that they are seen as highly speculative but are generally thought to be on the investment side of the line (see “The good, bad and ugly,” below). 

In all of these situations, one is making decisions where the outcome has some degree of uncertainty. The outcome may also depend upon the actions of others. Stocks’ performance, for instance, often react more to the general movement in the market than the fundamentals of the stock itself. 

For success in stocks, one has two crucial elements: general uncertainty about the economy and the product’s acceptance and the effect of competition. 

An analogous situation is found in a gambling context such as sports betting on the Super Bowl. The general uncertainty affects the outcome of the game whereas the competition from other players shows up in higher or lower odds. 

What then, is the difference between investing and gambling? In investing one buys some item, be it a stock, a bar of platinum or a waterfront house, pays the commission to the seller and goes off, possibly for a long time. Nothing prevents all participants from gaining.

In fact they usually do. The essence of an investment is this: It is possible for every person buying the item to gain and it is generally expected that most people will in fact reap profits. 
In leveraged investing—and some may argue gambling (particularly professional gambling)—performance is more based on finding an edge and employing solid bet sizing and risk management elements. This involves the construction of hedges comprising combinations of long and short risky situations where one makes a moderate profit most of the time with little risk. This is the basis of some successful hedge funds and bank trading department strategies.

The colocation of money and math

Both traders and gamblers should be especially wary of advice of the doubling up strategies: Martingales, pyramids, etc. While such systems may allow you to make small profits most of the time, the gigantic losses you suffer once in a while result in overall losses in the long run. 

The most useful result that we have for unfavorable games is that if you want to maximize your chances of achieving a goal before falling to some lower wealth level, you should use bold play. With bold play you do not let the casino defeat you by grinding out small profits from you along the way. Rather, you bet amounts that get you to your goal as soon as possible. 

Consider roulette, which is an unfavorable game with an edge of minus 2/38, or minus 5.26. Assuming that you are not able to predict the numbers that will occur any better than random, then you should bet on only one number with a wager that if you win you will either reach your goal or a wealth level from which you can reach it on one or more subsequent plays. 

If your fortune is $10 and your goal is $1,000, then it is optimal to bet the entire $10 on only one number. If you lose you are out. If you win you have $360 (with the 35-1 payoff) and then you bet $19, which takes you to $1,006 if you win and $341 if you lose. Upon losing you would bet the smallest amount again ($19) so that if you win you reach your goal of $1,000, etc. This bold play strategy always gives you the highest chance of achieving your goal. 

On the other hand, as in the case of roulette, the casino has the edge and your goal is to reach some higher level of wealth before falling to a lower level with as high a probability as possible, then ”timid play” is optimal. With timid play, you wager small amounts to make sure some small sample random result do not hurt you. Then, after a moderate number of plays you are virtually sure of winning. This is precisely what casinos do. With even a small edge, all they need to do to be practically guaranteed large and steady profits is to diversify the wagers so that the percentage wagered by each gambler is small. 
With crowded casinos, this is usually easy to accomplish. A simple example of this idea, non-diversification, shows up in many if not most or all financial disasters.

Intelligent wagering

The point of all this is that if you are to have any chance at all of winning, you must develop a playing strategy so that at least some of the time—and preferably most or all the time—when you are betting you are getting on average more than a dollar for each dollar wagered. We call this changing a gamble into an investment. 

The basic goal in the mathematics of gambling and investment is to turn gambles into investments with the development of good playing strategies so that one can wager intelligently. The strategy development follows general gambling situations to yield profitable systems. This frequently involves the identification of a security market imperfection, anomaly or partially predictable prices. In gambling situations all players cannot win, so the potential gain will depend upon how good the system is, how well it is played and how many are using it or other profitable systems — and, most crucially, on the risk control system in use. 

Nor will every game have a useful favorable system where one can make profits on average. Baccarat or Chemin de Fer is one such example. However, virtually every financial market will have strategies that lead to winning investment situations. 

There are two aspects of the analysis of each situation: when should one bet and how much? These may be referred to as strategy development and money management. They are equally important. While the strategy development aspect is fairly well understood by many, the money management (risk control) element is more subtle and it is such errors that lead to financial disasters.

This analysis is partially based on consultation with six individuals who have used these ideas in three separate areas: Market-neutral hedge funds, private futures trading hedge funds and racetrack betting to turn essentially zero into more than $1 billion plus. One, Jim Simons of the Renaissance Hedge Fund, made more than $1 billion per year during 10 years. All six, while different in many ways, began with a gambling focus and retain this in their trading. They are true investors with heavy emphasis on computerized mathematical investing and risk control. They understand downside risk well. They are even more focused on not losing their capital than on having more winnings. They have their losses but rarely do they over-bet or non-diversify enough to have a major blowout like the three hedge fund disasters.

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About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.