Money Management, Edge, and Position Side Trump Charts and Indicators for Cryptocurrency Investing
Chariots of the Gods
Excitement, anticipation, awe. The thrill of seeing something new for the first time releases powerful chemicals in your brain. Swimming in a cocktail of dopamine you see the potential of your discovery. At last, you have the key to the life you are destined for. The life you’ve always wanted.
On the 23rd of May 1995, three well-dressed twenty-somethings walked into a casino in Monte Carlo. Three hours later they walked out with over one hundred thousand US dollars in profit.
It was nothing to do with luck.
It’s fabulous, it’s glamorous, and it’s true.
But our heroes had a secret.
Meet the MIT blackjack team: Brilliant mathematicians and scientists, alumni of the Massachusetts Institute of Technology, they have a system based on a beautiful mathematical formula.
It meant they simply couldn’t lose.
In 1959 Ed Thorp, a brilliant young scientist joined MIT.
On holiday in Las Vegas, he tried his hand at blackjack. Thorp being a scientist, did his homework and found a scientific paper describing techniques where you could lose more slowly by narrowing the house edge during the game.
There’s something special about blackjack. The odds of winning are different than almost every other game of chance.
In a game of Russian roulette, there’s always a 1 in 6 chance of being killed. Each pull of the trigger is an independent event because after each pull you spin the chamber, and as long as you spin the chamber the odds of being shot is always the same. 1 in 6.
What happens if you don’t spin the chamber after you pull the trigger?
Played this way, each pull of the trigger is now a dependent and not an independent event and affects the likelihood of the next chamber being live.
As cards are removed from the deck in blackjack, they are not replaced, just like no-spin Russian roulette. Thorp realised this meant specific cards being removed from the deck changed the odds of winning in the players favour at certain times during the game.
In casino blackjack, you have to beat the dealer. The winning hand is the hand closest to 21. If you go above 21, you’re bust, and you lose. In most casino games the cards are always returned to the deck so they can be played in the next hand. This is like spinning the chamber in Russian roulette. In blackjack, removed cards aren’t returned to the deck and stay out of play, and this changes the odds of drawing an advantageous card during the game.
Like no-spin Russian roulette, each hand in blackjack is not an independent event.
Mathematically it means the game has a memory.
And this can be exploited.
During a game, a player can “stick” or refuse to draw further cards no matter what the current value of their hand. But a dealer can’t. At 15 the player can “stick” to reduce their chances of going bust. The rules in casino blackjack state a dealer can only stick at 17 or higher, so if the dealer has a hand of 16, the dealer has to draw another card. And if there are more high-value cards in the deck, the dealer is more likely to go bust. At this moment the house edge is removed and the probability of winning swings in favour of the player.
This is an edge, and the MIT blackjack team made millions from it.
It works like this…
Each card in the deck is assigned a value.
2-6 cards are given a value of +1.
7-9 cards are given a value of 0.
10-ACE cards are given a value of -1.
As each card is dealt out of the shoe, you keep a running count based on the value of the card, and if the running count increases the edge shifts to the player and away from the house. A higher running count means the ratio of high-value cards to low-value cards is higher, and if this ratio is higher, the dealer has a higher likelihood of drawing a higher value card and going bust.
The system is more complicated today because the casinos began using multiple decks. Multiple decks add a layer of complication because we have to adjust the running count into a “true” count to allow for the number of decks remaining.
If you have a running count of +10 and two decks remaining, the true count is 10 divided by 2 or +5. A count of +5 is the game telling you there are five more high-value cards than low-value cards remaining.
The key to using the true count is to adjust your bet sizes higher when the true count rises, because the odds of winning are in your favour, and readjust them lower when the count goes down.
It is beautiful in its simplicity.
What has blackjack and card counting got to do with cryptocurrencies?
What do the most successful blackjack players, poker players, financial market and cryptocurrency participants, from hedge funds to successful home-based traders have in common?
They understand their edge, and they focus on their risk and not the reward.
The reality is this: if you don’t understand what your edge is and if you don’t know how to combine it with money management and position sizing it will be next to impossible for you to make consistent returns in any market.
Have you ever thought about this…
Why do the people who know what they are doing live the life you want?
It’s because of the profits.
5% take the cash from the 95%. It’s as simple as that, so what do the 5% do that the other 95% do not?
Most new traders start by opening an account. The average deposit is $30,000. Brokers offer all sorts of help too— they provide basic training. They explain how technical analysis works and show you how to use the indicators. Things like moving averages, stochastics, MACD’s the list goes on.
Brokers also helpfully describe how to place orders and the different order types available. They may even suggest “paper” trading with pretend amounts until you are ready.
The trading platforms are impressive. Flashing lights, constantly changing prices, indicators, and news. Wow! How can you lose? Yet 95% do.
The reason? The 95% are looking in the wrong place, and they are focusing their attention on the wrong tools. They concentrate on the software and the indicators.
The 5% concentrate on understanding and exploiting their edge using position sizing and money management.
Duke and Duke
If you want a lesson in how the relationship between a broker and a trader works, watch the movie Trading Places.
As Randolph Duke explains, “Tell him the good part Mortimer.”
“No matter if our customers make money or lose money Duke and Duke get the commissions.”
Eddie Murphy does a wall break and looks into the camera, “It looks to me as if you two guys are a couple of bookies.”
“I told you he’d understand,” Mortimer said, as he pats Eddie Murphy on the shoulder.
Brokers are in the commission business. Most do a great job and provide a useful set of tools. They provide training for their customers because it’s in their interests for their customers to keep trading. They are in the commission business. You aren’t. In the wrong hands, the tools the brokers hand out can be lethal to your bankroll.
It helps to remember this relationship when you start using the tools they provide you with.
Here’s an example of 95% behaviour. Slap two moving averages, a fast one, and a slow one, on a chart, and when the fast one crosses the slow one to the upside, a buy signal is generated. They could also use something called an RSI (relative strength index) or a MACD (moving average convergence divergence) indicator to confirm the buy signal, and if confirmed they buy.
They’ve been taught to set a “stop” too. A price where they will sell and take a loss if they’re wrong.
You might be asking, at what price do I set my stop? And that’s a good question. An even better one is what happens to the trading results if I don’t use a stop?
Another great question to ask is — Do the 5% use stops?
The answer might surprise you.
A lot of the time, they don’t. Just in case you think this is trading heresy, remember this: It’s entirely possible to hedge your risk to breakeven or a small loss without setting a stop loss.
We’ll be talking about this in future articles, but for now, understand that you do not have to use stop-loss orders to manage risk.
A lot of brokers and chart service providers even let you backtest the performance of the indicators on the chart so you can see how much money you will make in the future.
So far so good.
Here’s a typical 95% day in the market.
You’ve got a plan. (although you probably didn’t think of it yourself)
You’ve set a stop.
And you’ve back-tested the plan and can see it’s made a ton of money in the past.
This is as far as most beginners go and it’s the reason most people don’t get to the next level.
Think about it. If all you had to do was add a couple of default indicators on a chart and buy when they flash a signal why doesn’t almost everyone win? Instead, why do 19 out of 20 lose?
It’s easy to get sucked into the mirage. You’ve been given a chariot to take you to the life you deserve. You’re prepared to do whatever it takes too. Hard work. No problem.
Don’t feel bad if this has happened to you. It happens to almost everyone.
Brokers and chart service providers give their customers dozens of built-in indicators to help make the job of finding profitable trades easier.
If you’ve used built-in chart indicators as a trading system, did you ever ask yourself any of the following questions?
If I enter here on this signal, who else has the same information as me?
If I enter here on this signal, who is on the other side of my trade? If I’m buying, who is selling to me, and if I’m selling, who is buying from me?
If the price does not do what I expect it to do, does this provide me with any useful direct market feedback on the next likely direction of price movement?
Why did I place my stop at this price?
If I can see this is an obvious place to put a stop how many other traders can “see” it too?
And most important of all— Do you make a consistent profit?
If so, congratulations.
But the problem is most people don’t make consistent profits, and they don’t ask the right questions. They may have some success, but over time they give it all back and sometimes more.
Know Your Poison
The indicators brokers and charting services provide are all attempting to do the same thing. They’re all trying to track momentum.
The theory is that momentum changes appear before price changes direction. It’s a great theory, but it only works some of the time. Most of the time it does not work.
Because momentum or momo indicators only work when markets are trending.
Momentum indicators are derived from the actual price. They are known as lagging indicators because they use previous price action in their calculations.
No problem, the intermediate traders reading this might be saying to themselves. You can use a trend recognition indicator like ADX (Average Directional Indicator) to tell you when the market is trending. Slap on an ADX and hey presto.
Now you only take the signal if the ADX is rising above 20, the RSI is above 30, and the fast moving average crosses the slow moving average.
Unfortunately, there’s a pesky little problem. It’s called Degrees of Freedom, it’s mathematically inescapable, and it’s a paradox.
Degrees of freedom works like a seesaw. The more you tweak the number of variables in the past in-sample data to remove the errors, the more errors will swing over into the future out-of-sample data.
In other words, the more indicators you add to a chart the less reliable the past will be as an indication of the future.
Your instinct and intuition know this, but because of the dopamine bath, you are currently enjoying, you ignore it.
Testing Testing 123…
Most of the 95% don’t get this far. The ones that do have their fingertips on what is required to generate consistent returns.
They start backtesting.
Helpful brokers and charting services even provide backtesting tools so that you can test your heart out. It’s well-intentioned, I’m sure, but have you ever thought about this…
Is the programmer of the backtesting software, an expert programmer or an expert trader?
Why ask the question? It's because most backtesting software providers do their backtesting the wrong way.
Can you answer this question?
What is the difference between in-sample and out-of-sample data?
Remember our paradox, the degrees of freedom? If you backtest your data in one lump, as most backtesting software does, when you tweak the variables to get the best results, you have, by removing the degrees of freedom from all your in-sample data, shifted the errors into the future. This means the future is very unlikely to perform like the past.
It’s easy to be disheartened because it all seems so complicated. At the outset, it looks easy. Fund the account, learn about the orders, learn how to add indicators and what they mean and also in some cases learn to backtest.
You thought you’d found the perfect vehicle, your chariot of the gods, to help you get the life you want.
If you’ve been frustrated with your results, it’s not because you’ve not found your chariot. It’s because you don’t know how to drive it.
Remember our story about the MIT blackjack team? They won because they used a simple system. Simple but not easy.
They understand their edge, and they know how to use it with ruthless precision.
It’s not charts, indicators, and stop losses. This is what the 95% use and this is why they keep crashing.
If you want to get to your destination, it’s edge, position size, and money management. These are the steering wheel, brakes, and clutch of your chariot, and just like learning to drive it takes time to coordinate how to use them.
Maybe you’re new, perhaps you’ve been on your journey and made it into the 5% club, or maybe you’re still looking.
It sounds easy, but it isn’t.
We’ll cover what the 5% do.
5% Club Admit One
Most traders, the 95%, focus on the flashing lights, they focus on the chart indicators. They focus on the reward. The 5% don’t.
They do this instead.
They ask the right questions.
And the right questions are all about this…
Risk of Ruin.