Gambling and SpeculationPosted: June 6, 2011
One recurrent topic in trading is differences and similarities between gambling and speculation. After having reads quite a few ideas on this I came up with the following definitions that work fine for me.
Both gambling and speculation share the same common ground and this is risk. Risk in turn has to do with the uncertainty of the outcome of future events so basically both gamblers and speculators have in common that they take risk with the objective of making a profit in the future but with the possibility of making a loss.
Even though both gamblers and speculators must take a non zero risk of ruin, a gambler is someone that takes a bet whose outcome has a negative expected value while a speculator takes risk only when the event has a positive expected value outcome or “edge”. There are many ways how speculators gain this “edge” but for automated traders usually it is based on studying the past (back-testing) and trading accordingly as long as they believe the fundamental process underlying is still in place.
Sometime ago I came up with the idea of the gambling / speculating matrix to visually represent the edge of any trading strategy. It is basically a two dimensional space where any risk game can be plotted and can fall in 3 distinct regions: gambling region, speculation region and neutral the latter being a game with a 0 expected value outcome.
Given a risk game X with a binary outcome, a probability Pwin of a positive outcome and a payout ratio R then a game will be
neutral if R = 1/Pwin – 1
a gamble if R < 1/Pwin – 1
a speculation if R > 1/Pwin – 1
The following is a plot of the neutrality line to show how it divides the graph into the to above mentioned regions. Please note that the y axis is plotted on a logarithmic scale. I find it very helpful to plot the expected parameters Pwin and R of my trading strategies in this graph to quickly compare them visually. Clearly the more north-east the better.