Unfortunately, money don’t fall from the sky like the above picture. In this post, I’ll talk about the very basic on how to make money as a prop. trader or professional gambler.
In this 5 parts article, I will talk about how to make money on your own, with the focus on making “alpha”* bets!
* You can interpret “alpha” as bets that have high probability of success – making money.
There are a lot of ways to make money in life. Basically, it comes down to providing goods and/or services.
– One can build a great product that people love. For example, Apple iPhone, etc.
– Another can provide great service that people want, such as real estate agent.
In terms of the finance industry, there are equivalent roles to above.
– For instance, sale traders can make a great sale pitch selling structured products, i.e. range accural, accumulator, etc.
– Execution traders provide great execution service to portfolio managers (PMs) to get the best average prices for the PM’s orders.
In the examples above, one gets money from others because one provides goods/services. You may wonder if there is another way to make money without providing goods/services.
Well, there is …
There is one more role in finance that is not based on selling products or providing services. It’s called proprietary trading (also known as prop-trading), where prop-traders make money (using his/her own money) by placing educated bets in the financial market. This is much like going to casino and wagering.
It sounds a great life, making money without doing work as in providing goods/services. However, let me warn you now and will repeat my warnings multiple times later on : Prop-trading is extremely difficult.
Let me start with this : Why do you think you can make money as a prop-trader?
- You think because you are smart? Well, there are a lot of smart people out there too.
- Ok, you think you are smarter than the others? Well, let’s see.
If you think you are smarter than others, you should know this is a zero-sum game. (If you don’t know this, I certainly suggest you NOT to play this game.)
By every $100 you are winning, it means other people losing $100. Thus, the sum is zero.
My opinion is that you shouldn’t think you are very smart, but rather there are a lot of people dumber than you. In other words, it’s not about how good you are, but how bad others are. You are ’smart’ RELATIVE to others.
To make a living as a prop-trader in financial market or casino, I will repeat again it’s extremely difficult. However, it’s not impossible. The first step to succeed as a prop-trader is to understand the game, after all, it’s a game, a game played in financial market or casino.
For example, quite a few people had asked me about Baccarat – a popular game played in casino. I don’t know anything about Baccarat. But a simple wiki look up tells you that Baccarat is a strictly a game of chance, with no skill or strategy involved. About 91% of total income from Macau casino in 2014 came from Baccarat.
Therefore, you should now know by playing Baccarat is just like rolling the dice, your chance of winning long-term is zero.
How about Blackjack (also known as 21)? Well, it’s still a game with under 50% winning for you. So how did those people at MIT (featured in the movie 21, who are indirect friends of mine) won?
You can look up on the internet how they did it, i.e. card counting. Essentially, it came down to getting more information which put them at an advantage over 50%.
Therefore, this is the second step in succeeding as prop-trader, getting more information to put yourself in an advantage position to play the game. If you have more information in one particular game than the other game, all else equal, play the game where you have more information.
Thus, which game above (Baccarat, Blackjack) do you have more information?
Definitely Blackjack in which you can leverage card-counting technique to gain additional information.
Other Examples :
– Insider trading (which is illegal), the insiders have the best available information, thus chance of winning is almost 100% if not 100% already.
– Sports betting, if you are following the sports very closely like a super equity research analyst covering a particular sector, you tend to have more information than others, thus your chance of winning is higher than others.
To continue from Part II which talks about one would like to choose a game where one has more information relative to others.
More information is always good, putting yourself in an advantage position. However, if everyone has the same information, then the information is useless. Thus, the key is not only you have the information, but rather more information than others.
This is the third step in succeeding as prop-trader : Who are your competitions?
Food for thought : in the above picture, if you have to pick a fight, who do you want to fight against? JJ Watts or Lionel Messi?
For instance, in the U.S., financial market players are largely dominated by institutions, hedge funds, passive and active funds, etc. These are your competitors. It sounds like stiff competitions. Indeed, it is. However, it’s not impossible. One, because your competitors performance is quite poor. In fact, more than half of the funds underperform the market index. There are a lot of reasons why. One of the most obvious reasons is that quite a lot of funds do not generate alpha, aka NOT prop-trading. They make money by collecting fee from clients.
Take the most popular poker game as another example : Texas Holdems. Who are your competitors in this case? All other players. However, not all players are the same. Let’s categorize them roughly into two categories :
1, One type of players are trying to make money, treat it as a profession.
2, Another type of players are playing for fun, making money is not their top priority.
Thus, who do you want to play against? Of course, you would love to play against the players playing for fun, they are risk-seeker in general, aka gamblers. Your chance of winning is higher when playing against “for fun” players. Thus, if you go to casino to player poker, I would suggest you to play at poker tables that have a lot of players playing a lot of hands, NOT a table of tight players.
Take sports betting as the last example. Who are your competitors here? Sports fans mostly.
Sports fans are fans, they are passionated about their teams, and more importantly – very biased. (Remember “biased” is human nature.)
They don’t analyze the teams, players, etc. They bet based on their irrational biased behavior. Therefore, you being the rational unbiased person would have a distinct advantage over sports fans.
Furthermore, not only sports fans, so-called professionals like GMs of teams make so many obvious stupid decisions as well. That’s why there are a lot of bad teams. This shouldn’t be surprised to you. If those professionals have high intellects, they are probably not in the sports business.
Therefore, playing at a game where you have additional information than others gives you an advantage.
To continue from Part III in which one would like to choose a game where you have less competitions.
It’s obvious to see the less competitions in poker or sport betting. What about financial markets? The players in this game tend to have higher intellect than the average population.
How do you outplay other players in this market?
Well, you need to understand what the players do and will do. For example, institutions investors usually rebalance their portfolio every 6 months. Non-hedge funds can only long stocks. Hedge funds can do anything, long/short equities, no set rebalance schedule, etc.
Therefore, this is the fourth step in succeeding as prop-trader : What do your competitors do?
It’s not about what you do, but what others do or will do that can give you ideas what you should do.
1, If you know what your competitions will do, you can front-run them. For example, let’s say the presidential election is 15 days away, if you think other players will likely get out of the market to play it safe. Then, you should go short the market before others sell.
2, If you know what your competitions do and why, you can take advantage of it by doing the opposite. For example, others fear of BrExit caused illiquidity, you can capture this liquidity premium. Once the dust is settled, aka situation/fear is not as bad as it seems to be. Liquidity premium is realized.
In fact, this is a psychological :
– When others do X, it pays to do the opposite. For example, in poker : when others are tight, you should be aggressive, vice versa.
Summarizing previous posts, to be successful as a prop-trader (casino player):
1, Understand the game you are playing.
2, Getting more information.
3, Choose weakest opponents.
4, Understand what your opponents’ moves.
These will put yourself in an advantage position to play the game. Of course, as you can digest, these rules above are correlated. For instance, if your competition is very strong, then his/her might have the same additional information as you and it could be much harder to understand and predict his moves.
Therefore, it comes back to the key point in Part I :
- It’s not about how good you are, but how bad others are. You are ’smart’ RELATIVE to others.
- Take the New England Patriots for example. Of course this team and organization is very good, from top to bottom, has the culture of winning formula. However, their successes are really magnified by how bad other teams are. The continuous mistakes other teams make are utterly incredible.