The Asymmetric Odds Of Short Term Trading

``We gamble because we are willing to accept the large probability of a small loss in the hope that the small probability of scoring a large gain will work in our favor, for most people, in any case, gambling is more entertainment than risk.”- Peter Bernstein, Against the Gods, [p.203]

In contrast to the conventional sell side analysts, normally I do not encourage short term trades. That’s because short term trades are not only risky, they also induce relative portfolio underperformance, by reinforcing our cognitive biases or by whetting our gambling ticks. In other words, they promote recklessness than discipline.

As investing guru and author Seth Karman wrote in the Margin of Safety, ``There are no winners in the short-term, relative performance derby. Attempting to outperform the market in the short-term is futile... The effort only distracts a money manager from finding and acting on sound long-term opportunities... As a result, the clients experience mediocre performance... Only brokers benefit from the high level of activity."

While the expected odds may seem like a median risk-reward distribution (50%-50%) for the typical market participants, the truth is short term trades have asymmetric odds or where the payouts aren’t equal.

For instance, short term trades in a maturing bullmarket will likely promote overtrading, where the frequency of gains leads to overconfidence and to constant churning of trades, regardless of the risk environment. The primary basis of trades are usually from charts (where past performance is assumed to deliver the same results) or market rumors.

But as the market reverses, the feckless market punters gets shocked into paralysis, and helplessly watch the cumulative “frequent” gains on their portfolio more than wiped out or expunged by the sheer horrifying magnitude of bear market losses.

This, in behavioral finance, we understand as the Prospect Theory, or where ``we tend to value a gain that is certain more than a gain that is less than certain, even when the expected value of each is the same. The opposite is even more true for losses: we will clutch at straws to avoid a certain loss, even if it means taking even greater risks.” (changingminds.org)

The proclivity for the mortal market participants or even many so-called institutional experts is to read or project interim trends into the future, where short term trends are construed as the “expected value”. For example, in the environment of rising markets, repeated gains from overtrading almost always extrapolate as vulnerability transforming into insuperability, risks are then read as risk free, luck is perceived as expertise and overconfidence morphs into hubris. The essence is that people take more bets than is warranted by the environment.

But as the market goes into a funk, the characteristics of the previous bullmarket as conceit, skills and the apparent risklessness reverses; denial, fear, desperation, despondency and the perception of a perpetually risky environment predominate. Some others will even “double down” to “avoid a certain loss” or “loss aversion”.

This innate tendency for the public to read into the market’s short term horizon signifies as the frequency of an outcome. People tend to tunnel on small but repeated occurrences than to look for probable magnitude of an outcome in a trade opportunity.

In general, the inherent shortcomings of short term trades are mainly due to the overemphasis on the frequency more than the magnitude of an outcome.