In this segment from our “Never Will I Ever” theme week, the Industry Focus: Consumer Goods team discusses wisdom from famed speculator Victor Niederhoffer on why most traders without an “edge” face ruin in the markets. A scene from a Hollywood classic, The Sting, nicely illustrates why your results can be held hostage by the size of your stake.
A full transcript follows the video.
This video was recorded on July 11, 2017.
Asit Sharma: Niederhoffer says, without an adequate capital stake, the trader is doomed. That’s my paraphrase of his point. Here’s an example I’m going to read for our listeners which illustrates why trading stake size is important.
He says, “Consider playing the following game with the brokerage house. Each day, you flip a coin. If it comes up heads, you win $1. If it comes up tails, you lose $1. But on every toss, the broker takes out $0.20. What are the chances of ending a winner after 200 tosses? The answer — about 1 in 100,000.”
Now, the house’s take is a function of this broker’s commission that we’ve been talking about, the vig. And trading costs have decreased since The Education of a Speculator was published back in 1998. Also, Victor is probably referring here to futures contracts, which have a higher trading cost. All the same, you need an edge in trading. That means, statistically, you have to be right more than 50% of the time. So when you hear people talk about an edge, they’re often not referring to a qualitative advantage, although that’s wrapped up in it. More often, it refers to your statistical advantage each time you trade. Even with an edge of 60%, let’s say you’re right 60% of the time, without an adequate stake to suffer through the periods of losses, a trader is doomed. You have to have enough capital to weather those periods. And this, in the gambling world, is a well-known phenomenon called gambler’s ruin. If you’re a trader who thinks of yourself as a speculator, you’re also exposed to this phenomenon. You have to have enough money to weather those storms. Vince, you and I talked about a really great scene from the movies, and that is in the movie The Sting starring Paul Newman and Robert Redford. Do you remember the scene that we’re talking about?
Vincent Shen: There’s a famous card playing scene on a train. Paul Newman, who’s the main character, has to try and essentially cheat the cheaters at the table that he’s playing…