Chris Perruna explains the basis of position sizing, expectancy and how poker has made him a better trader.

In writing this article he produces one of the strongest cases for using Trade-Ideas’ Odds Maker as a crucial risk management tool.

“How the Poker Craze Can Help You Trade“, (.pdf), November, 2006; Chris Perruna, founder and president of MarketStockWatch.com

Here are the main points:

Luck may and will play a small part under certain circumstances but rules, odds, risk and money management are the largest components of [poker and trading].

Back testing may help but playing sports my whole life has taught me that Monday morning quarterbacking is for theorists. Once a system has been tested profitably in real-time, the trader or poker player needs to follow rules in order to preserve capital and cut losses.

The traders must also consider the odds of their stock making a gain or making a loss. Price objectives and targets should be a large part of every investor’s system but it is not the essential ingredient to success. Understanding how much to trade or how much to bet and when to make that bet based on the system’s expectancy should be the top priority.

A system that has been tested will have an approximate expectancy that will tell the trader how much will be gained or lost during each trade over a period of time.

Most traders and poker players look for three major factors when developing a system: How much to trade or bet; The right odds or positive expectancy; Multiple trades or hands to play (opportunity)

What exactly is expectancy? Expectancy tells you what you can expect to make (win or lose) for every dollar risked. Casinos make money because the expectancy of every one of their games is in their favor. Play long enough and you are expected to lose and they are expected to win because the “odds” are in their favor. The same holds true for investing. If your expectancy is positive; you can make more money with multiple trades in shorter periods of time.

So what is my point? The point is that being more active or less active is not a way to guarantee success. You must formulate a positive expectancy system that balances the opportunities with minimal risk and maximum gain.

The Odds Maker by Trade-Ideas is not a backtester per se. It calculates the expectancy that Chris describes as an essential ingredient for initiating a trade.

I’ll repeat for emphasis:

The Odds Maker calculates a strategy’s expectancy BEFORE any capital is put at risk. We calculate all the components used in the expectancy calculation that Chris attributes to Dr. Van K. Tharp’s Book: Trade your way to Financial Freedom.

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)
Expectancy = (PW*AW) less (PL*AL)PW is the probability of winning and PL is the probability of losing. AW is the average gain (win) and AL is the average loss

The Odds Maker emphasizes the most recent market activity of the last 3 trading weeks (3 weeks vs. 10 years of data that some boast) to deliver what the expectancy of the strategy is, what the average winning and losing trades are for the strategy, and what net winnings are expected – i.e., what’s working right now; in this market. The Odds Maker does this by taking your exit preferences for trades and applying them to the strategy developed within Trade-Ideas Pro. The manual makes this point in more detail.

Chris’ article is an excellent piece of writing that draws a lot of positive behaviors a trader can employ to improve his/her trading. Here’s the kicker: Chris wrote this without seeing The Odds Maker. So guess who I’m going to chase down on Monday to extend a ‘kick the tires’ offer? Hopefully he’ll see the tool as an extension of his thinking.

What to learn more? Here is The Odds Maker FAQ.