Martin Kronicle

I like the idea of automating your payroll deductions to jack up your retirement savings account, such as your 401k. This type of forced discipline is very helpful, and I’m not putting you on. Sometimes it takes automatic deductions to get you going until you get the feel of it – literally and figuratively.

What I don’t like are the investment choices you’re given to hold your money. All of them are mutual funds and all are long-only. Now, you can model yourself after Gil Blake – and I encourage you to do so. He was featured in New Market Wizards for having masterfully traded his account using mutual funds, so it can be done. But like anything in life, you have to make an effort, you have to persist and be determined.

Here a list of things I don’t like about Mutual Funds. They are the same reasons why you might consider wanting to become a trader – someone who is skilled in risk management. I’m not concerned with debating the salient points of market timing yet…I’m doing that in an upcoming post. Just get your arms around some of these features/characteristics of mutual funds:

- Long Only vehicles

- have to be 75% invested at all times

- they are over-diversified: you need 12 stocks to be diversified. Why own 60+ stocks inside a fund – one fund? How many funds does one own?

- no liquidity b/c of forward pricing

- no risk management b/c of forward pricing

- leverage of 2:1 after 30 days in taxable accounts, none if in a retirement account

- no transparency

- fees can be less than clear

- 7 out of 8 managers underperform their benchmarks

If nothing else, you should be encouraged that these are professional managers we’re talking about. I see these bullets as handicaps.

Answer this question: How many people do you know who have become wealthy by investing in mutual funds?

The Intro Course on Commodities is now available online. You should register early to get into the first class.

I received a lot of emails to my post yesterday about the expected value of a trade. Only one person got the correct answer to the game of flipping 2 Aces off the top of the deck – what I’ll call the Game of Aces.

Now I can easily publish the correct answer, but that would rob you of an aha moment I believe, so I’m not going to do that.

The math behind playing the Roulette Wheel is why you’d never want to play it, despite the fact that you might get what economists call Economic Utility – pleasure or fun out of playing a game. For most serious traders though, losing money is not fun. Unless, of course, the trader gets more out of being a martyr or playing the role of victim, then it’s a different kind of game.

Anyway, to recap the Roulette Wheel, you have 38 spaces to bet on: numbers 1 through 36, a 00, and the blank space. It costs $1 to play and the winner pays $35.

Most of the answers I got from the Game of Aces, said “Yes, you play it all the time because you get $100 for your $1 bet, so that’s 100:1 – who wouldn’t want that all the time?” I think people get conditioned by the analysts on TV who suggest that “XYZ stock can go another $15 before we’d be worried.” They see the $15 as the payoff, but don’t see the downside risk.

What everyone left out was the frequency with which that result occurs. [For all the Lottery players, sit up straight and read closely.]

The payout ratio of the bet is irrelevant if the frequency with which it occurs is negligible. In the case of the Roulette Wheel, the payout ratio is in fact 35 to 1. However, the frequency (probability) with which you win per $1 bet is 1/38, or about 2.63% of the time. The other 97.37 % of the time you will expense your $1 bet. Playing this game with a fixed-budget constraint will surely make you Broke.

That’s why all the states in the Union market the living hell out of the Lottery as such a dreamy proposition: they sell you on what you could win, not the rarity of the occurrence. You’ll never win.

Spin the wheel 10,000 times (for $10,000 in bets), and on average you’ll get these results:

263 wins for $35 each = $9,210

9,737 losses of $1 each = ($9,737)

What’s compelling is not the 35:1 payout: it’s the frequency with which each occurs. So, if you’re lucky, and you come to the wheel and make $10,000 worth of $1 attempts, you’ll go home with $9,210 having lost $527 – the house’s edge. If you actually calculated the mathematical expectation from playing the Roulette Wheel, you’ll know it is – (1/19), which is -.0526 per attempt. Multiply that by 10,000 attempts and you’ll get approximately negative 527.

Think about this in the Game of Aces example from yesterday, and think about it next time you play Lotto. Don’t make a single trade with real money until you have an idea of how your thoughts manifest into winning and losing trades, and the frequency with which they occur. If you don’t care about this, you may be drawn to trading for the action, and not to make money.

The significance of mathematical expectation in trading.

In order to be successful in trading, you have to know what is called the expected value of a trade. Before you put capital to work, you should have an idea about what you stand to make or lose BEFORE you actually lose anything. You might consider paper trading: testing some ideas you have and recording whether you bought or sold short, how much capital you put to risk, and where you got out making or losing money.

You can call this your Trade Ledger – a list of all your trades – winners and losers. (If you are using backtesting software, it will do it for you.)

From your Ledger, you can begin to start thinking about mathematical expectation of your trading. This is important to the extent that whether you trade at a Prop Trading Firm or on your own, you’ll need to have a firm grasp on the expected value of a trade. You need accurate records to calculate this.

The significance of the expected value of a trade (based on your market calls) will tell you how much you expect to make on average by trading your set of rules, hunches, tips, or mood ring settings. By knowing this before you put capital to risk, you can save yourself a lot of money.

To get a feel for expected value, consider the following game that is proposed to potential trainees at a very well-run prop trading firm and market maker.

You are invited to play a game that will cost $1 to play. When you win, you’ll receive $100. If you lose, you lose your $1 only. So if you win, you’ll make 100 times your money.

From a deck of 52 cards, you must turn over 2 Aces (any 2 of the 4) in succession off the top of the deck – the first two cards. If you do that, you’ll win the $100. If not, you can try at it again for another $1.

If this was a trade, how frequently would you want to put this trade on? Anyone want to send me the solution?

If you get it right, I’ll publish your name (with your permission) for the kudos. You must send me the math.

I was quoted today in HedgeWorld on the likelihood of a commodity bubble.

My Platinum / Gold Spread study posted below was also highlighted.