When you trade forex, one observation you will often hear is that trading is gambling.
Rather than getting into a yes-no shouting match, let us look at gambling and trading to get perspective on the question.
People who liken the forex and share (equity) markets to gambling, are usually one of the following:
- People who do not know how trading actually works.
- People who have played the machines at casinos and lost.
- People who have traded forex with a gamblers attitude, that is, without understanding trading and without proper preparation for trading.
We’ll use roulette as our example, although what we explain here, goes for any type of chance games.
Roulette vs Fx trading
The roulette wheel in a casino has either 37 or 39 pockets depending on whether it is an European or American wheel:
- The European wheel has pockets numbered 1 to 36 with a single green zero. The single green zero gives the house (the casino) a -2.7% edge or advantage.
- The American wheel has 39 pockets (0 – 36 plus 0 and 00). The two zero pockets gives the house a -5.26% edge.
The bigger the house edge, the smaller the gambler’s chance of winning.
You can read more about roulette here
Is mathematics, gambling?
Casinos use mathematical models to calculate their risk and exposure to gamblers in order to stay profitable.
Forex traders use mathematical models (charts etc) to calculate their risk, exposure to the market and possible return.
So, if forex trading is gambling, mathematics must also be gambling.
Difference between trading and betting
Gambling or betting is a zero-sum game. You cannot lose only a part of the money you gambled. You lose all the money you put in the pot.
Forex trading allows you to prevent total loss of the capital you risked by tools you can use such as stop-losses.
Time: when the event on which you gambled has ended, your opportunity to make money (earn a return) also ends.
With forex, you can invest for long periods without your opportunity to earn a return disappearing.
Most gamblers lose, because the mathematical odds are stacked in favour of the casino.
- The basic bet on a game of roulette is to choose a black number or a red number. And then there is still the green or zero.
- If the gambler wins, the payout for the win is “even money” i.e. a R100 winning bet makes a R100.
- The casino has an edge in the green zero number.
- The mathematical probability is 18/37 that the player will win the bet, but then there is a 19/37 chance that the player will lose the bet.
- The result is that the casino has an edge or advantage of 2.7% every time a player places a bet.
- It is guaranteed (a mathematical fact) that over time, the player will lose the bet and the casino will win the bet.
- The guarantee is that much stronger because when the player wins a bet, he will, most times, play again because of previous success. And the more times he plays, the more times the casino will eventually win.
There are two main reasons why people lose money on fx trading:
- They bought at the wrong time.
- They sold at the wrong time.
How do the trader ensure that her trading does not become gambling?
Get “an edge”
You can make trading into gambling by surrendering the edge to the market. This happens when the trader or investor makes decisions on no other basis than luck. That is when buying and selling decisions are based on emotions and appearances not founded in probabilities.
Crossing a street at a traffic light while obeying the rules of the road is not gambling because the decision is made based on rules and probabilities (if you cross the road when the light is green for you, you will probably cross it safely). If, however, you cross the road where there is no pedestrian crossing and you just run in front of the traffic without observing your surroundings, you are probably gambling with your life. You have no edge.
The trader that wants to make sure that her trading does not become gambling, needs to keep to the rules of her trading strategy and trading plan.
Tools that traders use for this purpose are, amongst many others:
- chart patterns
- back-tested trading plans
- trading set-ups
- recurring chart patterns
- position sizing
When is trading gambling?
- Trading for excitement – trading for the emotional “fix” which is experienced regardless of whether one wins or loses.
- Social proofing – trading because others are doing it. This often occurs at the height of a bull market “when housewives become traders” and the fear of losing out entices people to enter the market.
- Trading to win, not trading a system – trading must be methodical and systematic because it is an odds-based activity. Trading to win leads the trader into losses such as holding on to losing positions hoping it will turn around and become winners. Good traders take losses as a cost of participating in the market.
The forex, share, index or commodity trader is not a gambler – as long as he follows the rules that make him the casino and not the gambler.