Trading does not create risk

September 10, 2015 01:00 PM

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One of the first rules I learned at Futures magazine was never to equate trading with gambling. Never to use gambling terms such as “betting” when describing trading activity. This seemed a little odd at first because the similarities are obvious and many traders had no such aversion to using these terms. And there were obvious similarities: Traders risk capital in the hope of making a higher return. From my days on the floor I knew that traders also liked to gamble on just about anything—it is part of the personality type of a risk taker: someone who likes action. 

Of course, the reason for the rule was sound. The futures industry was often looked down upon based on the belief that traders were nothing but gamblers. Through the years the industry faced outright restrictions based on this misplaced belief. CME Group Chairman Emeritus Leo Melamed pointed out to us in a past interview that the cash settlement fight was a controversial one because in prior court battles the only reason futures were not banned outright as gambling was because of the delivery mechanism that was part of all futures contracts prior to the creation of cash settlement.  

The notion of equating trading futures to gambling is specious because the purpose of futures and options markets has nothing to do with gambling. In fact, it is the opposite: So that producers and large consumers of commodities (and commodities for regulatory purposes are defined broadly) can offset price risk. That of course, is the hedging side of the equation. Speculators are the ones often derided as gamblers. They are allowed to do what they do because they make markets; you can’t only have hedgers, you need both hedgers and speculators to make a market. 

The best distinction regarding the difference between gambling and speculating was made to me by Leo Murphy, head of Trading Technologies' CampusConnect program and a former CBOT senior economist. Murphy tells students that gamblers create risk that wasn’t there before they place a bet; with trading, that risk—price risk in corn, soybeans, crude oil, Treasury bonds, etc.—already existed. Speculators will take on that existing risk, that hedgers do not want, in pursuit of profit. 

Also, some of the apprehension comes from a lack of understanding of gambling as much as trading. Some folks just see gambling as taking a chance on the lottery or playing a slot machine. Those of us with bad habits know that there is some skill involved that can improve your chances. Those that watch hours of football and study tendencies often will be able to pick winners better than say someone who simply bets on their alma mater. There are better and worse gamblers just as there are better and worse traders. 

For years we have published stories on all aspects of trading and money management that hit on themes that intersect with gambling. The math of sizing your trades (bet size) and choosing stop levels. We have covered the emergence of binary options, which break markets down to simple statistical odds from 0-100. Our cover story, “Where gambling meets trading” (page 16), includes several examples of where gambling and trading intersect. In “Wall Street bond broker turned Las Vegas race and sports book operator” (page 30), The Alpha Pages’ Managing Editor Garrett Baldwin speaks with CG Technology’s Lee Amaitis. Here is an odd instance of a firm with deep roots in financial and futures markets that actually is embracing the similarities with gambling and believe they can use their expertise in brokerage and market making to become a player in gaming. 

Gambling has long been seen as an illegitimate enterprise, which is why the business of trading wanted no affiliation with it. While there are broad economic purposes behind markets, as opposed to gambling, there are similarities. Trading, particularly in options, is a matter of pricing different probabilities and exploiting anomalies. Some of the best traders began as gamblers. Blair Hull started out counting cards before building an option market-making firm he would later sell to Goldman Sachs for more than $500 million. 

Gambling and trading are different, but people successful at either share qualities. They understand risk — they know what they are risking and for what possible reward — and they are able to quickly make judgements on whether the reward justifies that risk. They understand the importance of finding an edge and pushing it.  

To be successful at either takes hard work, research and a personality that’s able to handle stress.

 

 

 

Daniel P. Collins
Editor-in-Chief, Modern Trader
@moderntradered

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.