Remember the difference between a trade and a gamble. When you gamble, you are neither able to predict, nor have a control over the outcome. When you trade, you have control over both. This is fundamental difference is at the core of being a successful trader. Traders know their odds, understand their risks, make a mental note of their return expectations and work within these constraints.
Trading is different from gambling…
During one of the investment conferences, an eminent speaker was addressing a group of active traders in the market back in 2012. Asked why they trade in the market, the response were weird as well as humorous. Some traded so as to multiply their capital. Some traded for building portfolios. But most, it seemed, were trading merely for the thrill and the adrenaline of trading.
On a closer examination it turned out that most of the people in the room had made returns of 12-15% during the year 2012. This was not bad considering that a bank FD would have given them a return of less than 9%. But the real shocker came when the speaker informed them that had they put their money in an equity fund, they would have earned a whopping 45% in 2012, without the ulcers!
Quite apparently, these traders had never understood the fundamental difference between trading and gambling. There is a famous saying in Wall Street, “In the short term, the market may be a slotting machine, but in the long run it is always a weighing machine”. Focused on the short end of the market, they tend to miss out on the obvious bigger picture. But first, what are the aspects of trading?
3 CORE ASPECTS OF TRADING VIS-A-VIES GAMBLING
You know and measure your risk…
This is core to any trading activity. Be aware of the macro and micro risks that you are undertaking. Are you at risk of losing your capital? If you feel you are getting into a blind date, remember you are not a trader but a gambler!
Returns must justify the risk…
Knowing risk is one thing and evaluating returns is another thing. You want to ensure that you get compensated for taking the higher risk. Otherwise, it is the bucket shop that makes all the money. Exactly like a Casino!
Alternatives must be evaluated…
In the case above, traders earned 15% returns when passive mutual funds may have given 45% returns. That is a criminal waste of your risk taking ability. You need to constantly evaluate alternate returns, risk and capital preservation!
“The funny thing about stock markets is that both the buyer and the seller firmly believe that they are right” – William Feather
6 WAYS A TRADER SHOULD DIFFER FROM A GAMBLER…
- Never take a loss, just because it is limited. A trader is more interested in the likelihood of profits. The standard argument that buying options is a great idea because your risk is limited to the premium paid is erroneous. That is a typical gambler’s mentality. No loss is acceptable unless it promises returns.
- Capital preservation is the key. A trader typically focuses on capital preservation. Traders set limits of how much capital they are willing to lose in a particular trade as well as overall. In contrast, a gambler sets his stakes based on the size of the loss. He is willing to take a series of small losses.
- No loss is too small or too large for a trader. They do not come with mental predispositions. A trader always evaluates his trades based on the need to preserve capital and the likelihood of positive returns. For a trader, irrespective of the size of the potential loss, the likely returns must justify the same.
- A gamble has little or no control over the outcome. Be it the slotting machine or throwing a dice, the gambler will have no control over the outcome. A trader always operates with a Plan-B in place. While a trader may not have control over the outcome, he surely retains control of his actions in any event.
- A gambler really does not care about alternatives and the wisdom of losing money. A trader constantly evaluates alternatives. For a trader, money must always flow to the avenue that promises the best risk-adjusted returns. For a hard-boiled trader, riskless money takes precedence over uncertain money.
- A gambler operates in a discrete environment. He either makes money or loses money. A trader operates in the huge gap between these two extremes. For a trader it is not just about making or losing money but about capital preservation, managing risk and earning returns via the path of least resistance.
WHY THIS DIFFERENCE IS SO VERY CRITICAL:
In a way, most market watchers do not distinguish between a gambler and trader, since they both operate on uncertain outcomes. But the difference is the key to understanding the success of a trader. We have seen traders who keep buying deep out-of-the-money options since losses are known and limited. That is a myth. Over a period of time losses add up and deplete your capital. A smart trader would never follow this logic.
Buying deep OTM options because they are cheap or buying penny stocks just because they are priced cheap is living in a fool’s paradise. These are typical of a gambler. A gambler keeps eroding a small part of his capital regularly hoping that one day the uncertainty of the dice or the slotting machine will work in his favour. It rarely happens. A trader or an investor should never undertake even a basis point of risk, unless there is clarity on the probability of outcomes and the returns.
TAKEAWAYS FROM THE “TRADER VERSUS GAMBLER” DEBATE…
At the peak of the market correction in 2008, gamblers were buying call options on specific stocks hoping for a bounce-back. Sadly, it was the peak of a bear market and the bounce never came. Most gamblers were happy that they lost just a small premium on these options. That is not the way a trader would have seen it. The risk return trade-off was strongly in favour of buying puts and the gamblers were buying calls because their focus was on the small loss.
The difference between a trader and gambler is critical to understanding the dynamics of the market. The gambler tries to bet on uncertainty. A trader focuses on how best he can manage risk. The gambler is reconciled to the fact that he has no control over the outcome. The trader typically operates with a Plan-B in place. A trader is obsessed about preserving his capital. A gambler does not care as long he can live in the mirage of small losses. This difference lies at the core of being a smart trader!