What Hollywood Can Teach You About Day Trading

Markets Motley Fool

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.

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A full transcript follows the video.

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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 with. Ultimately, it's a longer game, and the idea in The Sting is how Paul Newman's character, in order to be successful for himself in this game, has to sustain some of these ups and downs, to not only have the edge that you were referring to, but you have to have that adequate capital, in his case, having the money to put on the table.

Sharma: Yeah. It's a long trade. I really recommend this movie if you haven't seen The Sting. It's so great, and there's a lot to learn about life, and even the markets. Many great investing metaphors in it. It's a very tense scene, and it elapses time of a several hours long poker game. In order to have an adequate stake to cheat the bad guy, Paul Newman's accomplice earlier in the film actually steals the bad guy's wallet without his knowledge just before the poker game starts. But he needs that much, there's like $15,000 in the wallet, and he needs that much just to be able to get to the point at the very end of game where he can take the bad guy's money, which sets up a chain reaction of events which is pre-planned by Paul Newman's character and his accomplices to get back at this bad guy, whose name is Mr. Lonnegan. Without this adequate stake, he couldn't survive the poker game, and neither can you, listener. Neither can I. If you want to trade and learn how to speculate, don't go in with $1,000. You should have an adequate amount of money that you can afford to lose, and learn exactly what your edge is. Until you actually go through that, you actually don't know statistically how good you are against the markets.

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