Odds, Money Management, and Roulette

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I want to spend some time thinking about Roulette and pot odds vs. probability odds and how it all comes together in trading for me. I am not a proponent of straight martingale money management systems. Let me say that up front. But as I go down this road, I believe it is helpful for me as a trader to understand more about it; mainly why is it used and can I pull something from it?

“A martingale is any of a class of betting strategies that originated from and were popular in 18th century France. The simplest of these strategies was designed for a game in which the gambler wins his stake if a coin comes up heads and loses it if the coin comes up tails. The strategy had the gambler double his bet after every loss, so that the first win would recover all previous losses plus win a profit equal to the original stake. The martingale strategy has been applied to roulette as well, as the probability of hitting either red or black is close to 50%.”-Wikipedia-

Martingale is a system designed to do two things:

1. Beat a system where the odds are either flat or stacked against the player by…

2. Expanding the time it is possible to play the game

In a game of random events, the odds are never in your favor. The coin flip is actually the closest. Its 1:1 but it doesn’t favor a certain player. Now look at roulette! There are 38 individual places on the board corresponding to the same 38 places on the wheel. That gives a player 37:1 odds of hitting an individual number. All other bets are lesser forms of this. Red, black, even, odd are all possible bets with odds that are more like a coin flip, 1:1. So money management systems like martingale are used to fight back so to speak against odds that are not in a players favor. Winning a random event game is about elongating the time played. The house has the advantage as they have a time advantage. They can out roll or out spin almost any player because as it says above, with an infinite stack, martingale works, and most players don’t have an infinite stack. The house, even if they started with the same amount of capital as a player, has the time advantage because the odds favor them and they win every bet a player losses. That being said it buys the house time to force the player out. I am sure there is a mathematical equation to describe this but I’m not that smart.

So what does this have to do with trading?

I have already determined that trading is different than gambling so that stands to reason that trading has an advantage over any form of random event gambling.

1. Roulette, and most forms of gambling, are almost 100% random event games. Trading is a market place that is made up of people with memories and ideas and rational plans of where they want to buy and sell a financial instrument. The Buying and selling, the competing rational forces are what make trading not a random event game

2. Change in payout odds (what I can gain on a given trade) in trading DOES NOT translate to a change in probability.

Number one is straight forward. I’m not going to spend time explaining it again. Its in the last post if you would like to go back and read it.

Number two is the edge.  Martingale assumes coin flip odds and consistent pay out odds. 1:1 on probability and 1:1 on pot odds. What if I could change that? What if probability odds stayed 1:1 but pot odds went to 1:4? Remember, the Roulette table WON’T LET THE PLAYER DO THAT? Why? Because at least some of the advantage shifts to player.

Let me explain. In roulette, I want to bet the best odds on the table so I bet black or red or odd or even. It’s 1:1 probability and 1:1 payout. If I wanted to try and tilt my pot odds and get 1:4 or $1 bet returns $4, I can’t stay at 1:1 on my probability odds. It jumps all the way to 5:1 on probability odds! I gain no advantage.

Here is a snap shot of one of the spreadsheets I built as an example of how this could work in trading. What this does it exactly what a roulette table won’t let you. Increase payout odds and maintain constant probability odds. Rules are a three trade limit per day and doubling of the principal at risk on every trade. NOT, I repeat NOT the size of a stop loss. That must remain constant.

Martingale Chart

1:1 probability odds with 1:1 payout odds doesn’t work. 1:1 probability odds with 1:4 payout odds actually makes sense to me IF I have at least a 1:1 chance in my game. Matt and I talked about it and this is almost employable on a purely naked chart, coin flip situation.

N0w, If my system sucks and I don’t have at least a 1:1  probability,  I will lose 70 dollars every day. But that will happen regardless of if I employ this idea or not. This may actually limit it to just the $70 a day…

Again, thank you for entertaining my ideas. I hope they spring some even better ones up for you. More to come

TradingLife:FindTheEdge

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