Pick the Easy Games
Like many sociopaths, Frank Wallace was a fan of the philosophy of Ayn Rand. He wrote a book called “Poker: A Guaranteed Income for Life”, started a cult based on Rand’s philosophy of objectivism, and got convicted of tax fraud.
“Poker: A Guaranteed Income for Life” is about getting edges in poker by playing weak players. The main character, John Finn, gets himself invited to a variety of home poker games. He creates a carefree atmosphere at the games, he befriends and encourages the weaker players, and slowly and carefully, he extracts their money.
In short, he’s a con artist. But he’s a con artist who has correctly identified that the most reliable way to make money playing poker is to play in easy games.
This lesson can be applied to trading.
The smartest decision you can make in trading is to play easy games.
What are the easy games in trading?
- Passively harvesting risk premia is an easy game
- Relative return prediction (cross-sectional strategies) is easier than making absolute return predictions (time series strategies)
- Immature markets (e.g. cryptocurrencies) offer more alpha opportunities than mature markets (e.g. FX)
- Capital-constrained statistical arbitrage can be very profitable for smaller traders and scales well within and across asset classes
- Cross-exchange and cross-timezone statistical arbitrage strategies offer opportunities for those willing to do the admin work and carry risk over market close.
You’ll notice that these “easy games” all have something a little distasteful about them. Harvesting risk premia involves taking on short term risks and skews in exchange for long term expected returns. Cross-timezone statistical arbitrage involves tedious admin work and risks which are hard to hedge. Trading cryptocurrencies involves credit risk, regulatory risk, jump risk and a hundred other risks you’ve never heard of before.
The easy games might not be the ones that you want to play. They might not be the most fun. But they are the most profitable. And having lots of money is fun.
Play a Different Game to Everyone Else
Joseph Buchdhal has written a number of excellent books on fixed odds sports betting.
As you read through his books in chronological order you observe his progression from an optimistic sports bettor who believes they can out-handicap the betting markets, to believing that the betting market price itself is the best prediction possible.
This leads the sports bettor to the realisation that, if she wants to make money, she needs to play a different game.
She might not be able to make absolute predictions that are better than the market – but she might be able to systematically exploit short term pricing inefficiencies on the way to price equilibrium.
This will sound like a familiar journey to the successful trader…
Maybe you’ve tried to predict the fair value of a company by analysing financial information? Or you’ve tried to calculate the fair value of an exchange rate by looking at economic data?
The market typically humbles such earnest efforts. The current market price is almost certainly as good a prediction as any you can make with public data, however slick your Excel modelling skills may be…
Just as the successful sports bettor doesn’t try to out-predict the market line, the successful trader doesn’t try to make heroic market predictions.
The successful trader plays a totally different game entirely.
There are short-term relative pricing inefficiencies that are still pervasive in the markets.
A good example is the over-reaction and under-reaction we see, on average, before or after certain events. These effects can be exploited systematically over a large number of independent bets; the Price Earnings Announcement Drift (PEAD) trade being a textbook example.
Other examples include short-term relative misalignment in prices which can be exploited through systematic convergence trading, and predictable moves in option implied volatility around scheduled information announcements.
The trader doesn’t need complex predictive models to exploit any of these effects. The bets are obvious, and she just needs to systematically take the bets and let her edge play out over time.
This isn’t particularly sexy. It doesn’t involve exciting, novel research. Nobody wants to talk to you about these trades. But this is a profitable game to play.
The Most Important Thing Is To Stay Alive
“I hope to break even this month… I could use the money” – Professional Gambler
Every successful professional gambler is a grinder. They don’t bet the farm, because they know the most important thing is to not blow up.
Rather than looking for “life-changing bets” they take a large number of small consistent bets, allowing a small edge to realise itself over time.
They grind it out.
The same is true in trading. Over-sizing your trades will kill you. Shooting for the moon is almost guaranteed to lose you money over the long run. (Look at the price of far out of the money options if you don’t believe me!)
The successful trader grinds it out every day.
Every day he bets small and bets often and takes as many different bets as he can.
There’s a lot you can learn from successful gamblers. Just make sure you get some sunshine every now and then.