Are You Trading Or Gambling?

[Editor's note: StockSpotter.com is a system for trading stocks and commodity futures. John Ehlers is a well-known commodities trader, author, and the creator of MESA, a method of cycle analysis that he developed in the late 1970s. In the following interview, John discusses the difference between investing and gambling with TalkMarkets contributor, Ilene Carrie].

Ilene: John, in our last discussion about trading systems in general and yours in particular (Can trading be reduced to cycles, stresses and vibrations?) you mentioned Monte Carlo simulations and their use in measuring performance. Can you explain more about how you measure the performance of a trading system?

dice-586123_640John: Let’s start with comparing trading with gambling. The two have several things in common.  In both cases you put money at risk in hopes of gaining rewards.  In both cases you can lose, but with trading you don’t necessarily lose what you bet. The probability of success in both cases ultimately depends on the combination of the payout (how much?) and the probability of winning (how often?).  Everyone knows that the odds favor the house in gaming, which accounts for the success of the casinos in Las Vegas.

In trading, the “Profit Factor” (ratio of gross winnings to gross losses) is synonymous with “Payout.”  A good trading system might have a Profit Factor of 1.5 or more and might have 65% winning trades. Using such a system heavily favors the traders. So why are not most traders blindingly rich?  I will examine that question from a statistical perspective.

The most common way to assess the performance of a trading system is to look at its equity growth curve.  Each trade profit (or loss) is added to the sum and plotted along a time line.  We can artificially create a statistical track record by assigning the Profit Factor to a winning trade and -1 to a losing trade.  That way, profits are normalized to the losses.  As we sum the trades we randomly assign winner or loser according to the probability of winning.

Ilene: Is it correct to say that the Payout or Profit Factor does not include the probability of winning, it’s simply the average amount of winning?

John: Yes.  The Payout is the amount you win if you win.  In trading, Profit Factor is analogous to Payout — but under the condition that a loss is valued at -1; i.e., the theoretical Payout of trading is normalized to the “average” loss.*

Ilene: How are the Monte Carlo simulations helpful?

John: The interesting fact from recomputing the spreadsheet several times is that you can get a lousy track record from a good trading system.  Worse yet, you can sometimes get a good track record from a lousy trading system.  This shows that a track record is not a particularly good method of judging the quality of a trading system. 

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Moon Kil Woong 5 years ago Contributor's comment

Thanks for showing the analysis of trading and gambling as a study in risk and reward. They are essentially the same, however, people are fed lies about how gambling is terrible and how investing in the stock market is great. In reality, it depends on the risk reward structure and sophistication of the trader or gambler. Given gambling is usually designed to offer a negative value if against the house. However, you will find the same thing but more sophisticated going on in the stock market and home buying as well. In the end, its buyer beware, and usually it involves those encouraging you to behave a certain way be in gambling, buying a house, or buying and selling stocks, mutual funds, ETFs, etc. In the end, those selling to you are hoping you are on the worst side of the trade or that they get a percent of your money like gambling casino houses always.