I also believed then, as I do now after more than fifty years as a money manager, that the surest way to get rich is to play only those gambling games or make those investments where I have an edge. ~Edward Thorp
What does it mean to have an “edge” in trading… or poker… or any structured competitive endeavor for that matter?
An old rule of thumb is: “If you don’t know what your edge is, you don’t have one.”
That statement is a helpful clarity filter. If you have a winning program, you should be able to articulate what makes you successful (especially in the context of a zero or minus sum game).
The phrase is unhelpful, though, in the way it muddies the waters. The single edge notion is a misnomer. A winning player has a critical mass accumulation of edges that all come together.
Because of this, it’s often a red herring, or a source of misdirection, to try and assign one or two large-scale reasons as to why a trader is profitable. There might be dozens of small-scale reasons, or something to that effect.
We can think about this in the context of decision-making at the poker table. Consider the following basic assumptions:
The typical casino room poker dealer, utilizing a table shuffle machine, deals about 35 hands an hour.
A skilled practitioner might play 20% of hands over time, and make important folding decisions another 20% of the time preflop. (The hands you avoid matter too.)
This works out to (roughly) 25 decisions per hour: 7 hands played to a flop or beyond… another 7 hands folded with discretion based on context (as opposed to insta-mucking queen-deuce offsuit etc)… and another dozen or so decisions in post-flop play. (Total = 26, rounded down to 25.)
By this estimation, the typical 5 hour session (4 to 6 hours of play) means 125 decisions.
A statistically meaningful block of time — to iron out luck, variance, outliers, etc — is about 100 hours, or twenty sessions. Any single session can be an outlier good or bad, but 100 hours of play gets you into relevant territory.
Over twenty sessions or 100 hours of play, at 125 decisions per hour, the skilled poker player has 2,500 decisions to make… which represents 2,500 opportunities to cement a cumulative edge.
Keeping in mind too that, if you really want to iron out the flukes, even 100 hours is a relatively modest unit of measurement. Taking it to a thousand hours — the equivalent of six months at a 40-hour-a week job — will really ensure whether the edge is there or it isn’t.
At that level, the skilled player has 25,000 chances to show superior quality… a compounding sum indeed…
Now, will all of those 25,000 decisions matter equally? Will they all have the same weight, the same impact on results? Of course not.
A relatively small percentage of decisions will have a gigantic impact on net outcome… decisions where very large pots, or entire stacks, are won or lost / protected or exposed.
(For the sake of simplicity, we won’t get into deep structure poker tournaments — but the outlier character of a few key decisions is even larger there.)
Then, in addition to the small percentage of massively important decisions, there are countless thousands of lower-stakes decisions that add up to big money via cumulative impact.
Twenty dollars here, fifteen dollars there, fifty dollars over there… get sloppy at the margins dozens of times a night and it gets expensive fast.
The vast majority of players — even those who think of themselves as “professional,” which is often code for “I don’t have a job” — do not think like this.
They don’t comprehend the sheer granularity of the game… how much the little decisions matter, and how important it is to get the big outlier decisions right. (Hello Risk Control!!)
Having an edge in poker, then, can be expressed in all kinds of generalized ways: Proper capitalization. Proper discipline. Theoretical grounding. Consistency in small pots, risk control in large pots, max extraction with the nuts, and so on.
But all of that can be boiled down to a simpler proposition: The ability to make consistently superior decisions, and consistently fewer mistakes, over an extended period of time.
In this manner, the skilled player is like “the house” in blackjack. Casinos welcome visitors to their blackjack tables because, even if you play with 100% theoretical correctness — a hard thing to do after three drinks — the casino still maintains a roughly one-half of one percent probabilistic edge.
Point being, even with an edge as thin as half a percent, the law of large numbers compounds to a point of near certainty.
There is a reason why casinos sell blackjack strategy cards in the commissary shops, and why all those blackjack dealers have jobs!
This further helps explain why the tourist or “casual” player is so hopelessly outgunned. There is a chance of “getting lucky,” certainly. But profitability over an extended cycle will be the cumulative result of good decisions made and bad decisions avoided, on a compound basis over time.
To get that you need repeated trials and consistent execution, over and over again. You need the patience of an unhurried regular.
There is admittedly a conceptual flaw in comparing a winning poker player to the house take in blackjack. In blackjack, the house edge is mathematical and statistically embedded in the rules. You can’t overcome it without counting cards or making high roller side deals with weak-minded staff.
The winning poker player’s edges, in contrast, are much more varied and subtle.
Go back to that roster of 25,000 decisions over a thousand-hour period. That multitude of decisions will cover what one might call a possibility landscape, in which all manner of outlier scenarios will cycle through, requiring all manner of nuanced knowledge expression as the correct moves are made.
Good runs, bad runs, wacky flops, epic suckouts, nightmare beats, super-nuanced weird or bizarre scenarios that come up almost never, and so on… It takes experience, an unflappable nature, and a very strong core process to handle all that with optimal precision, which in turn results in max profit.
And to a large degree, the manifestation of this edge is invisible… The bad player does not recognize the good player simply via straight-up observation. If the good player sits down with the same group of bad players over a long enough time period, the bad players simply get a nagging feeling: That guy always seems to win.
Now let’s move the discussion over to trading. What does a trading edge look like? Some ruminations…
Trading is far more complex and nuanced than poker, due to the far larger possibility landscape. But, for the sake of example, we can make some simplifying assumptions…
A discretionary swing trader with a multi-day to multi-week time frame might make, say, twenty trades a month on average (some months more, some months less).
Each of these trades involves at least four decisions:
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- When to enter
- Where to set the risk point
- When to exit (assuming RP not hit or otherwise adjusted)
- How much size (how big to make the trade)
Nor does the above consider partial profit-taking, pyramiding, holistic portfolio decisions, hedging strategies, and so on.
From a basic bread-and-butter standpoint, though, twenty trades per month creates the potential for eighty separate decisions. And in reality, there are many more decisions than that, as the trader has to decide which tempting trades to “fold preflop”… i.e. potentially attractive setups not taken for various filtering criteria reasons…
Then there are meta-level decisions to be made regarding things like:
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- Base levels of aggression relative to market conditions
- Levels of drawdown tolerance relative to equity curve
- Strategy implementation relative to market environment
- “Special tools” – special situation trades, structures, etc.
And on top of that, there are decisions as to where to direct research efforts… which research leads to follow up and which to back burner or the discard pile… potential R&D adjustments to the current methodology… whether to tweak at the margins in periods of adversity or stay with the tried and true… and on it goes…
Put all the above together and our baseline discretionary swing trader, who “only” makes twenty trades per month on average, still has to make something on the order of 200 decisions — remember all the stuff that’s said “no” to — all of which have a potential impact on cumulative net results…
So it’s fairly safe to say: As an active trader, you could literally be making thousands of decisions per year!
And just as with poker, your net will be the cumulative result of your decision-making quality (good diluted by bad)… with the stuff you leave out as potentially impactful as the stuff you put in…
You might have noticed that, in terms of sheer decision-making numbers, poker beats trading by an order of magnitude.
But trading ultimately trounces poker for a couple reasons:
In trading, the pot size is virtually unlimited. If you flop aces full of kings in a cash game, you can’t say “excuse me guys, let me just run out and add $50,000 to my stack.” With trading, in contrast, in those rare situations where an absolute dream opportunity comes up, it is possible to participate in gargantuan size, with capped downside risk. While high-stakes cash games can get ridiculous (think hundreds of thousands on the table), the stakes will always be peanuts compared to the potential depth of opportunity in trading.
In trading huge opportunities can last for months, quarters, or even years. An excellent trading methodology is one that allows for large size on initial entry, via carefully managed risk point, coupled with an ability to “open up the envelope” on truly excellent positions that can run and run like the energizer bunny… and offer opportunities to pyramid along the way. Think of sick runs like crude oil transitioning from hovering above $10 per barrel to nearly $140 pre-crisis, or stocks like Enron falling from hundreds of dollars per share to zero.
In trading, you can make money while you sleep. Poker requires a presence at the table in order to win. You can’t hire someone to drag the pots. With trading, in contrast, you can put a great position on and then sit back and let it work. If you are riding a great trend, the trend will keep going while you fish on your boat or play with your kids. Patience, aka the ability to “sit tight,” is a time-saving virtue in that regard. As Jesse Livermore once said (via Reminiscences),
“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: it never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!”
In this piece we haven’t touched on the dynamics of all those decisions — thousands, tens of thousands — and the detail that actually goes in.
A deeper purpose of this exercise, though, is to demonstrate at least three things:
- A real edge is more durable than most realize.
- Developing a real edge takes EFFORT!
- The long-run investment is WORTH IT.
There are optimists who come into trading (or poker) expecting it to be easy. But this notion never made much sense. Why would a zero-sum game — in which whatever profit you extract comes from your fellow participants, with house vigorish on top — be easy?
Reaching the promised land of consistent profitability isn’t easy. It’s hard. Like “training to compete in an Ironman” hard.
That’s the bad news. The good news is this: The fact that it’s so hard is part of what validates the edge as real.
The edges are numerous. There’s a nearly infinite number of ways to skin the proverbial cat, as it were. There are behavioral edges, temporal ones, analytical edges from macro to micro, quantitative, trade structuring and management edges, and the list goes on (I know, I know…. you quants out there are reading this and shrieking but calm down, I’m talking to the discretionary traders and investors here, so we’re using the term loosely).
Most pigeon-hole themselves into a particular approach seeking to exploit a very particular edge. That’s great. Nothing wrong with hammering away at something that works. But if given the right knowledge and resources, it’s ideal to stack as many edges on top of one another is it not?
Why only look for fundamentally misvalued stocks if you have the ability to look for fundamentally misvalued stocks, that are trading in sectors showing historic quantitative discounts with increasingly positive relative momentum, that reside in markets with positive macro tailwinds and supporting structural capital flows?
One edge is good. Many edges are great.
This is what we’re focused on at MO. It’s something we call Conditional Edge Stacking. Discretionary trading and investing are incredibly challenging. That’s why we look for every opportunity to tilt the odds in our favor. We want to stack conditional edge upon edge upon edge…
In tomorrow’s follow-up piece, we’ll go through a recent Case Study of how this process was applied to one of our portfolio holdings, a leading LatAm retailer that most haven’t heard of.
We’ll walk you through how we analyzed the macro to identify a secular and cyclical growing country and market… then used quantitative metrics to filter through the abundance of garbage and value traps… and finally, we’ll discuss how we applied our micro lens to find an under the radar company with a large margin of safety and incredibly positive asymmetries.
Stay tuned…
