Is trading like poker? A strange question you might think but actually there are a number of similarities and making the comparison can help improve ones trading strategy. Adam Hartley explores the similarities and differences between the two and finds that learning about poker can improve trading performance.
There has recently been a great upsurge in interest in the game of poker, not least because of the recent TV coverage of the World Poker Tour where you can see the hands that the players have and watch their decisions as they make bets for huge sums of money. Traders are of course making similar decision with large amounts of money on a daily basis and like professional poker players, looking to make a living from this process. Can studying the habits of winning poker players help traders improve their performance?
Firstly, for those who are not familiar with the basics of the game need to be outlined. All variations of poker (and there are quite a few of them) come down to the relative rankings of 5 cards in each players hand. Players bet on their hand according to how good they think it is and at the end the player with the best hand takes all the money in the pot. The hands are ranked according to how likely they are to occur with the rarer hands beating the more common hands. The rankings are as follows:
High Card: if all else fails the highest card wins
One Pair: having a pair, i.e. two cards of the same rank
Two Pairs: having two different pairs
Three of a Kind: three cards of the same rank
Straight: a sequence of five cards in ascending order of any suit
Flush: five cards of any rank but of the same suit
Full House: three of one rank and two of another rank
Four of a Kind: four cards of the same rank
Straight-Flush: a straight but all cards also the same suit
Some variations of poker give you more than five cards and the best five cards are selected to make the final hand. Most variations involve several rounds of betting on the cards as they are dealt out before the final showdown. Some have communal cards that everyone uses whereas other variations keep the cards separate to each player.
Having dealt with the basics of how the game is played the next question is how do professional poker players play the game and what can traders learn from this?
The first and most important point is that poker, like trading, is all about expectations. This does not mean looking forward to making all that money, rather the expected value of a bet is the amount that you earn on average from it. If a bet of $1 will win the pot of $10 25% of the time and the rest of the time results in the loss of that $1 then the expected return from the bet is:
0.25 x $10 + 0.75 x -$1 = $1.75
That is to say, on average you will make $1.75 every time you find yourself in this situation and you make the bet. This is clearly a good bet to take as it makes you money on average. On an individual basis each bet could go either way but over a period of time it will average out to a clear profit. On the other hand if the bet will only win 5% of the time then the expectation is
0.05 x $10 +0.95 x -$1 = $-0.45
This is clearly not a good bet and over time will lose you money. That’s not to say that you cannot win this bet and some times you will be lucky but over a period of time you will be a net loser.
In the famous Market Wizards books Ed Seykota said that there are good trades and bad trades, and winning trades and losing trades and that these are not the same things. A good trade is one with a positive net expectation and a bad trade is one with a negative expectation and these are not the same as winning and losing trades. The job of a trader or poker player is to take good traders or bets and not bad ones and to let the winning and losing take care of itself. This is often something that people have problems with: they get hung up on the winning and losing rather than whether what they are doing has a positive expectation. If the expectation is positive then the numbers will work out in the end. One way to think about it is to think that when you are making a trade or bet you are buying a piece of expectation and that if it is a good quality piece of expectation then over time this will crystallise into actual money but that your job is to seek out and purchase the best pieces of expectation that you can buy. If you make a good trade or bet then irrespective of the actual outcome you need to tell yourself that you’ve done the right thing and to keep on doing it. The worst thing that you can do if you get a run of losing bets or trades is to start deviating from a positive expectation strategy.
Having an Edge
In order to have a positive expectation you need to have an edge. If there is no edge then you cannot get a positive expectation. There is a good reason why there are no professional roulette players: you cannot get a positive net expectation from any plays because of the house edge.
In poker they talk about how “tight” a player is. That is how disciplined and selective he is about what cards he chooses to play. One of the basic mistakes that rookie poker players make is in playing too many starting hands (the cards that you are initially dealt) that don’t have a positive expectation. In other words they are far too “loose”. A professional player knows that only the best starting hands are going to make money over the long run and so they spend most of their time folding their hands, waiting patiently for the best quality ones to come along. A poor player on the other hand will bet money on mediocre hands far too much. And what happens to this money? It ends up in the pockets of the good players who have had the discipline to wait for those big hands and to rake in big winning pots as a consequence.
A professional poker player can almost guarantee to make money over the long run in a loose game being played by relative amateurs. His edge in this case is in playing only the best quality cards and waiting patiently until they come along. You can try this for yourself with on-line poker games where you can even play with pretend money. Because there is no real money for stake people tend to bet on anything. If you play a disciplined and tight game then you will always come out ahead in the long run.
What’s Your Edge?
So how does what we’ve said so far relate to trading? As with poker, trading is all about expectations, making good bets and not bad bets, buying good pieces of expectation and letting the winning and losing trades come and go. Its about having an edge. Ask yourself with your trading what your edge is. Why is it that you expect to make money from what you do. A market maker has an edge which is the spread in the market that he is trading. Because he gets the right side of the bid and offer he has a positive expectation on his trades. Sure there will be times when the whole market turns bid and he’s the one selling to all those buyers but he still has an edge which will always win out. For the rest of us this spread is part of the costs that we have to bear when trading and these costs are significant. Our net expectation on each trade must be greater than all our costs per trade for trading to be worth doing at all.
Using this analogy of tight poker playing when thinking about trading can help you become a better more disciplined trader. When contemplating a trade, ask yourself are these the best trading conditions and do I have a genuine edge here or should I wait until better “cards” come along? Unlike in poker when you are forced to bet at least twice each time the dealership passes round the table (the small and big blind bets are forced bets that players have to make before they even see their cards) in trading there is no cost in not trading so sitting there waiting patiently for the right conditions to come doesn’t cost anything. It’s well worth remembering that you don’t have to trade and there is no point in doing so unless the conditions or trade set-up give you an edge. Over-trading is the trading equivalent of playing too loosely with the same devastating financial consequences.
The Only Game in Town
One of the most striking differences between poker and trading is the level at which the game is played. In poker you can get games with the stakes as low as a couple of cents for each bet all the way up to no limit games where tens of thousands of dollars are at stake. As you can imagine the higher the stakes the better the quality of the players. Fortunately the rookie player can start off at the bottom where the amounts risked are manageable and the opposition relatively inexperienced.
With trading on the other hand whilst you can still make small sized trades when starting out the opposition that you are playing against includes the best on the planet! There is only one game in town for any given market so if you want to trade that market then you are in effect doing the trading equivalent of sitting down to play at the poker table with seasoned professionals. Clearly someone starting out in poker would balk at having to do this but they are quite happy to start trading with little experience at all. It is no surprise that the vast majority of traders lose money when it is viewed from this perspective as they are playing in a zero-sum game with the best players who have learned how to win at this game. If you want to think of it in Darwinian terms then survival of the fittest certainly applies to trading: the losers drop out of the game leaving only those who win and new players who have just joined the game.
The moral of this observation is to be cautious with trading. I have often seen people who have been successful in other areas of business and who’ve made some money who come along thinking that trading is going to be easy. For the reasons pointed out above it is not easy as you are up against the best players in a zero-sum game. That’s not to say that trading can’t be successful but that it requires discipline and patience to succeed.
No doubt you’ll not be surprised to learn that there is an important psychological aspect to poker just as there is in trading. There is of course the element of reading opponents and bluffing but in addition to this there is the issue of managing your own emotional state. There is an expression in poker for when a player starts playing emotionally and irrationally, it’s called going “on tilt”. This very often happens after someone has taken a big loss, they try to make it back by playing hands that they shouldn’t and making bets that they shouldn’t. Other players love it when a player goes on tilt because it means that they will make more money from his bad decisions.
This is of course a common failing also with trading; monitoring and managing ones emotional state is an important part of the trading process. As traders we’ve all experience this but it is vital to learn to monitor ones emotional state before placing trades. If you go “on tilt” then stop trading. Remind yourself that you need to be looking to buy good expectations and the money will take care of itself.
State of Mind
Top professional poker players need to keep a clear head. Contrary to what you might think, the vast majority don’t drink alcohol at the table as they need to be able to do the calculations and make the assessments with full concentration for hours at a time. In trading one’s state of mind is often overlooked, trading when not feeling 100% can lead to mistakes and making trades which don’t have good expectations. Remember, unlike in poker, it costs you nothing not to trade.
So what have we learnt from this comparison between poker and trading? Firstly that without an edge of some kind there is no point in making a trade. Waiting with discipline for the right “cards” or trading conditions to come along is the basic edge and once you deviate from this then your edge is gone. Monitor your emotional state. Are you “on tilt” – should you walk away from the table. Remember there’s only one game in town and you are playing against professionals so unless you trade in a professional manner they’ll end up taking all your money! Stick with your strategy, buy “good expectations”, trust that the numbers will work themselves out and you will succeed.