Saturday, May 16, 2009

Another Poker/Trading Analogy (trading, gambling)

Many people have written or talked about the similarities between poker and trading as professions. Mostly these discussions focus on the characteristics of the players and the traits of the successful and unsuccessful participants. Usually things like how being fearless, having good discipline, good money management, a quick mind, and the ability to be decisive are common to both good poker players and good traders. Instead, I'm going to point out what I think are similarities between the different games of poker and the different trading strategies that are their equivalent.

I am one of those who believe that poker is not a card game, but a betting game. There is no play of the cards (suits, rankings) and the role of the cards is simply to determine the winner of the betting, while at the same time providing different states of probability along the way. Because of this, the different ways that people are allowed to bet are more important than many people realize. Similarly, there are many markets with varying degrees of liquidity and risk. Many traders also have different time horizons and risk/reward goals for their trades. What follows is my view of the trading equivalent of three of the most popular poker games and why it matters to know the difference.

Limit Holdem

In limit, the amount per bet is fixed and the number of raises is capped. This means that relative to each bet, the resulting pot you can win is smaller than at other games. This also means that the odds and implied odds for calling a bet while behind cannot be dictated by the player who is ahead. In the end, most successful limit holdem players are continually trying to grind out small edges and small pots. The trading equivalent of the successful players who play this game are the market makers, spread makers, arbitrageurs, and rebate players. These are the guys who try to take advantage of small edges and make them over and over again, knowing that they are not aiming to take all of someone's money on one hand.

Pot-Limit Omaha

In pot-limit, a player may bet or raise up to the amount that is already in the pot. This means that pots can become big by being progressively built. This style of betting is perfect for Omaha, where there are many different routes to end up with the best hand on the river. That means players will build pots whether they are already there (eg. top set) or plan to get there (eg. flush draw, wrap straight draw). Also, no matter how much you've committed to the pot, it is important to give it up when the wrong card hits (eg. you have top set and the river connects both a flush and a straight, chances are you're beat). I feel that the trading equivalent of pot-limit players are trend followers. Trend traders add into their position along the trend, hoping to ride it for a big payoff at the end. Similarly, these traders have to get out when the trend line breaks no matter how committed they've been in riding the trend.

No-Limit Holdem

The most popular of the poker games involves the ability to win big pots and make big bluffs. My feeling is that the equivalent type of trader usually consists of one or two individual traders rather than a well-oiled hedge fund machine, and these traders usually trade in the biggest or thinnest markets, usually currency, commodities, or energy markets. These aren't guys who get leveraged to make a tiny spread. They get leveraged for a big payout. These are usually the traders and poker players who tell you they only need to have about a 50% win rate because their winners are much bigger than their losers. The most memorable of these traders usually involve the biggest bets. Soros and Druckenmiller come to mind, and among the most recent, Brian Hunter. He was the trader that brought down Amaranth. From what I read, he knew the market was going against his spread trade but he thought he had enough resources behind him (2bil+leverage) to squeeze the market the other way. Sometimes you go all-in on a bluff and get called. Also note that while he made a big bet and lost, he wasn't a rogue trader like Kerviel or Leeson.

It is important to identify these differences in betting style/strategy because not everyone can excel at all of them. One other thing in common between poker players and traders is ego. While most players think they can do just as well in all the different forms and strategies, that is usually not the case. While nobody will really argue against Phil Hellmuth's skills at NL Holdem tournaments, when he sits down against the best cash limit holdem players in the world, he's practically giving away money. Similarly, you can frequently spot a trader who thinks he's better at making spreads but whose buy points usually lead to 3% moves that he never takes advantage of. It is important to really know what kind of trading you excel at, just as it is important to play the game of poker that you're best at.

Also, no matter the size and scope of your operation, the basic style is the same. The difference between a daytrader trying to ride a half hour trend and a PM riding an 8 month trend is like the difference between playing 1/2 and 10/20. A trader who makes a market in one stock every day and a quant who runs a market making program in 15 stocks is the difference between a guy playing 1 table and one of those internet pros 15-tabling the poker games.

Finally, let's not forget the Bernie Madoffs. There is the equivalent of a ponzi scheme in poker. I don't know the correct term, but here's an example. A guy sells 50% of whatever he'll win to someone for the entry fee. This is a pretty normal type of staking arrangement in poker. However, the same guy can now go to someone else and make the same deal. Now he's sold 100% of himself, but taken in twice the buyin. All he has to do now is put up a good show, not cash, and he's got himself a risk-free equivalent of one buyin.

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