Professional Blackjack players have a tiny but significant edge against the House, which is why they are quickly banned once the casino identifies them. The source of this edge is card-counting. The goal of card-counting is to identify the composition of the remaining cards in the shoe and to bet bigger when the deck is “tens-rich”, i.e. when it contains a disproportionately high number of tens and aces. To understand why this gives the player an edge, imagine that the shoe contains only cards with a face value of ten and higher. In this case, there are four possible outcomes of a hand:
- You have 20 and the dealer has 20: you push (you get your money back).
- You have 21 and the dealer has 21: again, you push.
- You have 20, the dealer has 21: you lose 1 unit.
- You have 21, the dealer has 20: you win 1.5 units (blackjack traditionally paid 3:2 but now, more often, it’s 6:5).
It’s easy to see from this that playing with such a shoe gives you a huge advantage – over a long enough series of bets, you cannot lose. The goal of card-counting then is to identify situations when the actual composition of the shoe tends towards this ideal and to bet bigger when this is the case and smaller (or not at all) when the reverse is true. This is the source of the professional Blackjack player’s edge.
There’s one other important point I wish to make about Blackjack before I relate Blackjack to trading. A professional Blackjack player NEVER bets using intuition. He would never say to himself “I feel a high card is coming, I’ll stand pat.” On every hand, there’s always one correct action based on your cards, the dealer’s up card and the current count – and every alternative is wrong. If a professional ever deviates from the correct strategy it would only be because the correct action would simply scream to the Pit Boss “Hey, get over here, I’m a card-counter.” How’s tricks, Ben?
If you want to learn more about card-counting, the seminal work on this was written by Edward O Thorp in the 1960’s.
So, what has this got to do with trading? Quite a bit, actually.
Just like a professional Blackjack player, a professional trader should be able to state the source of his edge. In the case of the trader, this means providing answers to the following questions:
1. What is your model of the market that interprets the market’s actions?
2. Are there any predictable market behaviors in your model that can provide a trader with a positive expectancy?
3. Can these predictable behaviors be exploited by a trading plan that provides entry, exit and trade management criteria?
When evaluating different trading methods (including the one you are using now), you should try to get answers to these questions. If you can’t, then you don’t have any idea why you should be profitable and consequently you probably won’t be.
It’s definitely not sufficient to say something like “I buy when the 5 period EMA is above the 13 period EMA and price retraces to the 5 EMA.” What facet of market behavior are you exploiting? Why do you expect the market to turn at the 5 period EMA? Why did you choose these periodicities? Would other EMA periods work too? Why an exponential instead of a simple moving average? Where do you expect the market to go after entry and why? What market behavior would indicate you’re wrong? Etc. etc.
Trading is not a video game. You should understand the rationale behind your trades and be able to state what you believe to be true about market price action and why your method should produce profits.
Different traders will have different answers to these questions – assuming they have bothered to even ask them. If you understand those answers, you can then decide for yourself whether or not you believe them too. If you don’t truly and wholeheartedly believe in the source of a method’s edge, you will not be able to trade it successfully even if it works – you will sabotage your own trading because of your lack of conviction. Trust me on this!
As an example, an Elliotician might say that “I believe the market moves in series of 5 waves and 3 waves. If I can correctly identify where we are in this series at the right edge of the chart, I can predict whether this next swing will be up or down and how far the market ought to go. I can thus construct an entry at the predicted end of the current swing.” Essentially, that’s the way a follower of Elliot Wave Theory thinks. I don’t believe that the market follows a prescribed path of 5 waves and 3 waves – why should it? This is enough for me to know that I need not pursue any strategies based on this theory. Note that I’m not saying it doesn’t work, only that I don’t believe it does and so I could not trade an Elliot Wave method with real money.
Similarly, a financial astrologer (don’t laugh, they do exist) might say “I believe that the market price action is dictated by the movements of the Houses of the Zodiac. If I can know, based on the natal chart of the instrument, which House is in the ascendant, I can construct an entry based on the effect of this House and exit when its influence wanes.” You might believe this, but I couldn’t possibly comment: I’m a typical Leo and don’t believe in astrology.
Another trader might say “I believe the market moves according to predictable cycles. If i can identify the dominant cycle in the market, I can reduce this to a sine wave and make trades at the peaks and troughs of the wave.” I don’t believe there is any persistent cyclicality to markets either, so this is not for me.
So, having given some examples of what I don’t believe, I’ll now explain what I do believe, which will make your job a lot easier. If your beliefs about the market are not consonant with mine, you will not be interested in Auction Profile even though you have to admit the charts are pretty.
I’ll try to be concise as this is a blog post not a book – look at the Methodology section for more in-depth information on the rationale behind Auction Profile. In brief though, my model of the market is informed by Auction Market Theory.
I believe that the market has two basic states: balance and not-balance. When a market is in balance, there is a somewhat predictable nature to price movement. Price tends to oscillate from one extreme to the other as price tends to overshoot value. This is the source of a potential trading edge. A trade taken in the extremes of a balance can be expected to have one of two possible outcomes: either, the balance will continue and price will move to test the opposite extreme of balance; or, the balance will break. Both outcomes are roughly equal in terms of probability (I’ll explain why in a later blog post) but the reward of a trade taken in anticipation of balance continuation exceeds the risk, which is to a price where one can say that the balance has broken.
That’s it. It’s a logical, testable method and you will either tend to agree or disagree with these beliefs. Furthermore, it’s a straightforward matter to construct an unambiguous trading plan to exploit this perennial facet of market behavior using the tools provided on an Auction Profile chart. If you do this, you will trade consistently and narrow your freedom of actions once you see the entry setup – it should be as mechanical as possible. Like the professional Blackjack player, you will not use intuition during a trade but will follow the preset plan. Unlike the professional Blackjack player, you won’t have to worry about being banned.
You there, Ben?