How Does Leverage Affect Trading Returns? The Kelly Criterion | Coffeezilla Follow-up

welcome back to patrick boyle on finance it's a little while about 12 days i think since i've posted a video here but as an awful lot of you obviously know i did an interview on monday on coffeezilla and it was loosely based around the idea of trading gurus and day trading the video just came out a few days ago and it has cost my number of subscribers to more than double so it took over a year i guess to get my first thousand subscribers and i've gained about seven thousand in the last few days so i'd like to welcome all of the new subscribers on board and i hope you guys continue to enjoy the content here if you haven't seen the coffeezilla video i'll put a link to it in the description below and so today we're going to talk about the use of leverage in trading and how it might affect your trading returns an awful lot of this is based on some of the questions and comments from the coffeezilla video and we'll look at a few lessons from the world of gambling and see what a trader might be able to learn from professional gamblers we'll discuss whether anyone can easily make a living as a day trader and we'll discuss the topic that seemed to offend some people the most uh the statement that i made saying that the long-term returns of funds like george soros's or warren buffett's or steve cohen or a place like renaissance technologies that their returns of around 20 a year which is around twice the return of the stock market i said were actually amazingly good returns and that a day trader should not reasonably expect to make more than those investors over any long period of time okay so the first thing we can discuss here is how smart are the people that you're trading against in the market an awful lot of the online trading coaches like to tell you that you can spend 15 minutes a day trading from the beach and compound massive returns in fact i think i even saw a video a while ago of some guy like trading from a helicopter above london which i imagine means a very slow internet connection if nothing else the reason that you'll get such great returns is that they're going to teach you some amazing tricks and that you're competing against what they call dumb money the idea is that when you buy a stock you're buying it based on their really smart system but the person selling it is some old person selling it in order to pay for their retirement and that person doesn't have a clue i can tell you first off that most of the people that you are trading against are full-time traders and they're very smart one of my friends that i used to work with is a physics phd who became a trader after about 10 years of working on the large hadron collider in switzerland he now works at a large bank writing algorithmic fx trading strategies that truthfully will eat you alive if you don't know what you're doing when he started out his current firm a group of his more senior colleagues i remember complained to his boss that his trading was destroying their p l his boss told him that they had better just come up with better trading strategies then another two friends of mine opened a fund in london a few years ago and had most of the roads in the city dug up in order to install their high-speed trading lines and i've asked them in fact to give me advanced warning if they're planning on moving office so that i can take a holiday and avoid the traffic congestion caused by all the roadworks another person i know had an atomic clock installed in his office a little while ago i'm not exactly sure what he's using it for but these are the people that you're up against or at least you're up against some people like these they're very smart they're very well capitalized and they spend the money that's needed in order to consistently grind profits out of the market and they're not at it for 15 minutes a day they're there all day every day so when someone tells you that you can sign up for their course to cost two thousand dollars and start earning two percent returns per day right away it's kind of like a guy at your gym telling you that he's going to show you a few tricks and that you can now step into the ring with conor mcgregor i'm not saying that you can't win as a day trader but it's unreasonable to expect it to be really easy and you should be aware that the majority of day traders do lose money now that doesn't mean that you will it just means that you need to do a bit more work than some of these guys like to tell you is needed okay so next up the topic of transaction costs lots of people commented that they trade for free on robinhood while people like me have to suffer transaction costs of course you don't really trade for free and i kind of touched on this in the interview whenever you look at the price of a stock or an option or any other financial product you're usually going to see two prices on the screen one is the price that you can buy at and the other is the price that you can sell at the buy price is always the higher one and paying this spread is a significant trading cost now often if you try to buy will say a hundred shares at that price you might only get a single share or one or two shares out of the 100 at the price that was shown and the rest of your order will get filled at a higher price at a worse price because high frequency traders get in front of your order buy it ahead of you and then sell it on to you at this new higher price a lot of retail brokerages are often compensated by high frequency trading firms to route their orders uh to them so that they can do this and this is just to tell you that nothing is free if you think you're trading for free you're not trading for free they're just getting it out of you a different way now it's worth noting as well that options have significantly higher commissions are trading costs wider spreads than stocks do and maybe one of the reasons that your online trading guru is suggesting that you trade options is that the brokers are possibly giving them some sort of kickback on the trading fees that you generate okay so next up is my argument that the level of leverage that the trading gurus are recommending you use is excessive and will wipe out your account a friend of mine wrote a behavioral finance piece a few years ago once again it's something i discussed on coffeezilla he looked at how people bet on a computer-generated coin flip that they're told in advance has a 60 chance of landing on heads the coin flipping experiment highlights how many of us even those who study finance struggle with how to correctly size trades prior to starting the game participants read a detailed description of the game which includes a clear statement in bold indicating that the simulated coin that they'll be playing with has a 60 chance of coming up heads and a 40 chance of coming up tails participants were then given 25 of starting capital this is real money and it was explained to them both in text and verbally that they would be paid by check the amount of their ending balance subject to a maximum payout which i think was around 250 dollars participants were told that they could play the game for 30 minutes and if they accepted the 25 stake they had to just stay in the room for the full 30 minutes the players were not randomly selected so they weren't just people off of the street they were mostly college students in disciplines like economics and finance and some were young professionals at financial firms so these were smart people my friend was surprised to see that sub-optimal bedding came in all shapes and sizes there was over-bedding bedding erratic bedding betting on tails even though you were told there was a 60 chance of heads there were just many things that players did that squandered their chance to take home the maximum win of 250. only 21 of the participants reached the maximum payout of 250 which is well below the 95 percent that should have reached it if they just followed a very simple strategy like betting somewhere between 10 and 20 of their capital each time they played one-third of the participants wound up with less money in their account than they started with right like you've been told there's a 60 chance of it coming up heads you can bet on it and that many people ended up with less money than they started out with more surprising is the fact that 28 of the participants went bust so they lost everything and received no payout so that's 28 went bust the fact that a game of flipping coins with an ex-ante 60 40 winning probability produced so many subjects that lost everything is frankly just startling the average ending bankroll of those who didn't reach the maximum and who also didn't go bust which was around 51 of the sample was 75 and so that's sort of okay they've tripled their initial 25 stake but it still represents a very sub-optimal outcome given the opportunity that was presented participants were generally very erratic with their fractional betting patterns sometimes they'd bet too small and then the next time too big and on and on so what is the optimal strategy in a game like this well if you're a professional gambler if you know anything about gambling there's a good chance that you've heard of what's called the kelly criterion which is a formula that was published in 1955 by a guy called john kelly who worked at bell labs it was further developed and applied to casino games and financial markets by ed thorpe in a series of papers and popular books most notably beat the dealer and beat the market and i'll put links to his books in the description below the basic idea of the kelly formula is that a player who wants to maximize the rate of growth of their wealth should bet a constant fraction of their wealth on each flip of the coin and that's defined by the function two times p minus one where p is the probability of winning kelly came up with his idea when watching the tv game show the 64 thousand dollar question which was a big tv show at the time viewers of the tv show at the time used to place bets with local bookies on which contestants would win and which ones would lose the show was produced in new york and it aired live there in new york and then it was shown three hours later in los angeles kelly read in the newspaper about a gambler in los angeles who learned the winners by phone and then would place his bets in los angeles before the show came out and the west coast bookies weren't aware of this and they let him place the bets and he won quite a lot of money and this sort of uh brought up an idea in kelly's head he tried to solve a problem that if there was a gambler who had some sort of private wire who got advance notice of the outcomes of things like horse races or baseball games things you could bet on if these tips were not a hundred percent reliable but they were accurate enough to give the gambler an edge how should this gambler size his bets the gambler he assumed could bet at fair odds that had not been adjusted for the secret tips right so he's the only person who knows the the winners and the other gamblers are setting the bets based on their perception of what the odds are now a really greedy better might just bet their entire bankroll each time the more you bet the more you can win but because these bets are not sure things once and the wildest gambler is going to lose the greedy gambler is guaranteed to eventually lose everything because even if it might be rare once in a while they're going to make a bet that wipes them out entirely now on the other hand an overly careful batter might make the minimum a loud bet every time this gambler is leaving an awful lot of money on the table they're squandering their edge this is a great opportunity that they're they're missing out on a gambler he theorized should be interested in compound return a lot like the way an investor is the best strategy offers the highest compound return consistent with no risk of going bust so this brings us to a statistical concept which is known as the law of large numbers the law of large numbers is a theorem that describes the result of performing the same experiment a large number of times according to the law the average of the results obtained from a large number of trials should be close to the expected value and will tend to become closer to the expected value as more trials are performed now that's a lot like our coin flipping so even though we know there's a sixty percent chance of getting heads if we only flip once you might not necessarily get heads but if you flip a hundred thousand times you should see sixty percent of the time it coming up heads and forty percent of the time at coming up tails now obviously as a trader as a gambler this means that if you do have an edge and you do have a large number of trades your returns over time should equal your edge less trading costs so what does the kelly system do it sizes the bets to ensure that the player basically just stays in the game long enough for the law of large numbers to work in gambling lots of proportional betting systems exist and existed before kelly what's special about the kelly system is that it grows your wealth faster than any other system betting more than kelly does really well if you have an early winning streak but if you over bet you'll be quickly wiped out and equally if you under bet you'll make money but you won't do as well as you should have done in the coin flipping example that we just gave the kelly criterion would tell you to bet 20 of your account on heads on each flip so the first bet would be five dollars which is twenty percent of twenty five dollars and you bet that on heads of course because the odds are that it'll come up heads if you win you then are going to be betting six dollars on heads which is twenty percent of the thirty dollars that you now have if you lost you would have lost that five dollars so you only have twenty dollars and the next time you'd be betting four dollars which is twenty percent of twenty dollars and on it go so you're always just betting 20 of whatever your bankroll is now as i mentioned some of the trading guru videos that i looked at were suggesting using 10 times leverage in trading of the most volatile stocks that are out there this implies that their trading ideas are significantly better than getting to bed on a biased coin like in the game that we're just discussing it's worth noting that with the biased coin experiment they capped your winnings at 250 and the reason for this is because someone betting the kelly system who was quick could make an awful lot of money in 30 minutes and in fact i think you can find an online version of that game and if you google it you can see how well you would do without the cap so can you use the kelly criterion in the stock market well there are many differences between the stock market and games of chance in games of chance there are distinct outcomes things like heads or tails in the above game this isn't the case for markets where the range of outcomes is a continuum stocks can rise or fall by any amount time in games of chance is broken down into discrete games while time in markets is continuous in the stock market an investor can remain invested as long as they want to and there is a non-normally distributed range of outcomes in markets transaction costs exist and no one really knows the probabilities underlying a trading system no matter how well they might estimate them in advance in his book ed torp hints that the most you would possibly bet in the market is half the amount suggested by the kelly criterion such sizing would give significantly more volatile returns than his funds ever had so i doubt that he actually did that he also mentions that bill gross of pimco apparently learned the kelly criterion back in 1969 from reading torp's book beat the dealer bill gross then went and played blackjack for a summer in las vegas using torp system and has gone on to say that its influence can be found throughout his investing approach not investing at all when you don't have an edge and investing heavily when you have a really good situation is characteristic of a kelly better while i wouldn't recommend using the kelly criterion as a market investor there are a ton of lessons that we can take from it the most obvious and important one is that excess leverage will definitely wipe you out that's something we definitely know there was some confusion in the comment section of the coffeezilla video as well about compound interest a lot of people didn't seem to think that the source buffered returns of around twice that of the stock market over a 30-year period was much of a big deal and they said that they could easily do much better than that i put together the chart that you see up there showing how a 1 000 investment would grow over 30 years if it's compounded at 10 percent a year or 20 percent a year and as you can see at 20 percent a year after 30 years your thousand dollars grows to 240 000 roughly and at 10 a year your thousand grows to just under 18 000. so a rather large difference in in ending balances and this is just the power of compounding this is kind of why compound interest matters it's why the trading guru promise of two percent a day is really obviously ridiculous because that sort of sounds like a reasonable thing like if you say to someone you can make two percent they say well that's not so much um but that small sounding daily return compounds out i had to do the calculation 137 640 percent and one of the viewers kindly calculated that in the video comments because some people were confused by that anyhow don't forget to like and subscribe and i will see you next week bye

Channel: Patrick Boyle

Views: 161,445

Keywords: finance, trading, patrick boyle, on finance, quantitative finance, financial derivatives, kelly criterion, trade sizing, trading and gambling, coffeezilla, trading gurus, fake gurus, george soros, warren buffett, Ed Thorpe, beat the dealer, beat the market, fortunes formula, https://www.youtube.com/watch?v=JfP4rVsmL_Q&t=2983s, make money online, day trader, lifestyle, the truth about trading gurus, risk management, bet sizing, kelly system, compound interest, 2% theory

Id: UjsC2sk7vVg

Length: 20min 5sec (1205 seconds)

Published: Fri Aug 28 2020