The longer I trade the more I come to the conclusion that you have to trade like a casino or an insurance company. No, I don’t mean that you should start thinking about setting up your own blackjack table or begin offering life insurance products, but rather that you should only trade the risks that you understand and stand aside the rest of the time.
The house edge in blackjack using liberal Las Vegas rules is only a miniscule 28 basis points. In baccarat it is 1.06% if you are the banker. In video poker it is just 46 basis points. The numbers are ridiculously small, yet they are enough to allow Steve Winn to buy Picasso’s, Warhol’s and Van Gogh’s and graciously display them in his art museum.
The story is the same with life insurance. If you are in you mid-thirties to mid-forties, a non-smoker, are not overweight and have no chronic medical conditions, it takes only about $1000 per year to obtain a $1M term life insurance policy. That seems incredibly cheap and you may wonder how insurance companies are able to offer such low cost protection. Do they just run a massive Bernie Madoff Ponzi scheme and refuse to pay off when you die? Well this being insurance some do, but generally they don’t have to. The odds of them paying out a claim on the type of cohort I described is just 1 in 60,000 which means they can expect to bank $59M each year from every 60,000 policies they sell. Not a bad gig.
Of course both insurance and casinos are basically fixed odds systems. Under the law of large numbers the payoffs are practically guaranteed. Trading is not as neatly forecastable by statistics. Unlike casino games the outcomes in markets are much more difficult to predict. Investment returns suffer from what is known as fat tails – events that under normal conditions would happen only once in every 10,000 years, occur in markets once every decade. That’s why in trading it becomes even more important to follow the casino and life insurance model and assume only the risks you can afford.
Suppose you’ve been playing blackjack for a while in Vegas and you are up 1M on the house. What happens? Do the pit bosses glower at you? Do dealers looks at you in fear and disgust? Quite the opposite. The waitresses offer you free drinks and ask if you would like a Kobe burger brought to the table all courtesy of the house. The pit boss approaches you and congratulates you on your recent winnings and suggests that as a gesture of goodwill the casino would be glad to put you up at their $10,000 night penthouse suite for as long as you like and will be happy to attend to your every need. What the hell is going on here? Why is the casino being so nice? Because they know that the longer you stay at the table, the greater the chances that you will give all your winnings back.
Now imagine you belly up to the blackjack table and place 100M worth of chips on a single bet. Do you think any casino would take your business? Of course not. Although casinos know that over the long run the edge is theirs, on any given hand the odds could easily favor the player and the prospect of 100M loss is much too great a risk to the safety of their business, Casinos trade only the risks that they know and stand down against everything else.
If only we as traders could follow such steely discipline.