“Gambling, noun. The practice or activity of betting : the practice of risking money or other stakes in a game or bet.“
Merriam-Webster Dictionary
Article Summary:
- There are transaction costs in both poker and trading. To run a profitable strategy in either game, traders need to identify situations where they have the edge over their opponents and only play when there’s a positive expected value.
- Similar to the recreational poker player, non-economic volatility traders, such as retail investors or pension funds, are often willing to purchase options at prices that may be misaligned from their true value due to differing goals and objectives.
- Despite the variance that comes with options trading and poker, even the best strategies can sometimes still lose in the short-term; however, it is ultimately a trader or poker player’s skill and edge that will determine their success in the long run.
There’s A Reason Many Professional Traders Also Play Poker.
Many poker players and options traders hate it when we refer to either as “gambling”, but even though they’re games of skill, it still involves betting on uncertain future outcomes. In fact, poker and trading is so similar that SIG — a major options market maker— hosts poker tournaments as a recruiting tool for new traders.
Here are some things poker players will immediately understand about options trading.
#1: It’s a negative-sum game
In a zero-sum game, one player always has to lose for someone else to win. In poker and trading, it’s even worse. the house always wins, even if the players don’t.
Whenever you sit at a poker table, you know that the casino is taking a commission (rake) out of every pot. Even at the lowest stakes, there are hundreds of dollars being taken off the table every hour, leaving less for you to win from the other players. In the options space, transaction costs are even worse, with retail investors trading weekly options with bid-ask spreads of 12% or more. Imagine trying to invest in SPY with spreads that wide!
Poker players only play a certain percentage of the hands they’re dealt. They win money over time by only playing strong, profitable hands that are ahead of those that other players might call with. Poker players also know they must play fewer hands when the rake is high. Marginal holdings minimally profitable in a game with no rake become losers when the casino starts taking its cut. Similarly, options traders must pick their battles when identifying which trades to take. Many backtested strategies appear to be profitable until transaction costs are factored in.
Without a large, quantifiable edge, a trader is better off not having any position. This is because buying a fairly priced asset (one that is neither overpriced or cheap) has no expected value. Making a trade without an edge merely costs you the bid-ask spread, commissions, and valuable time, so trades made on a whim and without an edge have a negative expected value. Like the poker player who plays Ace-King because they know they can win a large pot with a strong hand, we should only open positions when we know we have profitable trades. Don’t support your local market maker. Just because you can trade options doesn’t mean you should.
#2: We Play for the blinds
So when should we trade?
When playing poker, the two players to the left of the button have to pay a small and large blind. These blinds are the forced bets that the two players must put in the pot before each hand begins. The blinds exist to encourage action and prevent players from simply sitting around and waiting for premium hands. Without these forced bets, players would sit around waiting for the best possible hand (Aces) all day. However, players are incentivized to play a range of hands to win the pot because of the blinds.
Lucky for us options traders, there are almost always “blinds” sitting around in the market. Market makers and many hedge funds have to be long options, no matter the cost. Market makers love volatile markets since bid-ask spreads widen and trading volume increases. Buying options help ensure that in market turmoil, the market maker has enough liquidity to capitalize on these opportunities. Similarly, hedge funds might buy options to hedge their equity positions from market crashes, earnings announcements, and more. These firms know that buying options lose money over time, but they must pay the blinds if they want to play the game.
As retail traders, we should build our trading business around attacking these “blinds”. We don’t have the stringent risk limits of a hedge fund or the need for liquidity during market downturns. By selling highly demanded options, we can receive compensation for holding risks market makers and other hedge funds don’t want. Sure, we’ll see some drawdowns now and then, but we’ll happily take it knowing we’ll profit in the long run.
These types of trades are known as “risk premium” harvesting. This doesn’t imply that you’ll be paid for taking any risk. It means that when people dislike risks, they’ll usually pay you to take them on.
#3: Some players aren’t playing for money
When you sit down at a poker table, you’ll often find both “recreational” and “professional” players. Professional poker players are highly dedicated and invest a lot of time studying the game and developing strategies to win. They tend to have deep knowledge of the game’s nuances, as well as an extensive understanding of the odds and probabilities that they use to inform their decisions. In contrast, recreational poker players are typically in it for entertainment; they don’t study the game or develop complex strategies but instead focus on having fun. These players do not necessarily have a good understanding of all the intricacies of poker and may make decisions based on emotion rather than logic.
It’s every professional poker player’s dream to find themselves at a table full of recreational players willing to lose money to have fun for several hours. Similarly, there are players in the options space who seemingly give away money by selling options at a low IV or buying options with expensive implied volatility. This is because their goals are different.
In a 2012 interview, Maple Leaf Capital CEO Michael Wexler discusses how most participants in the options space are what he describes as “non-economic volatility traders”:
“If a retail investor wants to buy a call on apple because he loves the company and loves the stock, whether it costs 5% or 6% for that call option, he’s still going to buy it. He’s really not that price sensitive.”
In an interview on the Mutiny Investing Podcast, QVR CIO Benn Eifert talks about how price-insensitive options traders create opportunities for them:
The investment process that we run and the thought process behind it has always really been the same. That’s thinking about and understanding how dislocations arise in the derivatives market, typically driven by … an end user of derivatives, who isn’t some sophisticated arbitrager, is just a pension fund trying to do some risk hedging or a retail investor trying to buy a structured note.
Volatility traders see their counterparties making “mistakes” by trading volatility at incorrect prices because their goals differ. Similar to how recreational poker players are there to have fun, some options traders want to express a directional view with options, a volatility product. While many recreational poker players are accomplished businessmen, lawyers, and doctors, poker is just a game – they’re there for fun, not money. Similarly, “volatility fish” — who focus more on direction than implied volatility — allows us to profit from options with mispriced IV.
#4: Small hands play small pots. Big hands play big pots
Bet sizing is a well-studied topic in poker. The phrase “small hands, small pot – big hands, big pot” illustrates how you should play conservatively when you have mediocre cards but not hesitate to get the money in the middle when you have the best hand. Poker players make a common mistake: “overplaying” bad hands – betting far too much with weak holdings. Similarly, many players are too timid when they have a great hand, failing to extract the maximum value when they can.
Options traders tend to make the exact same mistake. Many retail options traders bet way too much money on their trades , which lead to them losing much more than they’re comfortable with when things inevitably go wrong. Big losses are much more important than big wins; when a trader loses 50% of their account, they have to double their money just to break even. Risk premium-type trades generally have a small edge, but the opportunity is almost always there. An example of a risk premium trade is the volatility risk premium; implied volatility tends to be slightly higher than the realized volatility, so selling options make money over time. However, when trading the volatility risk premium, large drawdowns occur during market crashes. As the VRP has a small expected profit and large drawdowns, trading in small size is recommended.
On the other hand, there are occasional “alpha” trades with a huge expected payoff and minimal risk. This typically occurs due to some transitory event (such as a huge fund buying many options on a stock or retail traders bidding up OTM call prices), and these opportunities don’t last. There have been trades where the options of an ETF were so expensive that I could completely hedge away all the risk for cheaper. I put my entire trading account into this trade once I discovered the arbitrage. If you have a royal flush, you should be happy to go all-in every single time.
#5: Embrace the variance
In poker and trading, it’s possible to do everything right and still lose. Even the best hand in poker can lose up to 23% of the time if you get it all in before the flop. There’s a lot of variance that comes with options trading, too – even the best strategies can be losers for long periods.
Variance is part of the game. If poker were like chess and had no luck component, the recreational players wouldn’t find it fun anymore. Recreational players need to get lucky every now and then to keep returning to the tables. Likewise, hedge funds and market makers wouldn’t need to buy overpriced options if there was no risk. Retail traders wouldn’t punt on SPY calls and puts if they didn’t hit it big every now and then. The variance that many traders hate is actually the reason their business exists, so good traders learn to embrace the variance and take the hits in stride.
In the long run, it’s your poker skill or trading edge that matters.
Conclusion
Poker and options trading share many similarities at their core. To excel in both games requires an understanding of which players to make money from, how to manage risk, and embracing the inevitable variance that comes with each endeavor.
