I realize that I haven’t posted any new content in a while, but I would like to thank you for your patience while I have been transitioning.
Anyway, today’s post will be different. I will teach everything that I know about the card game Blackjack and how learning this new skill can lead to a shift in thinking that can directly improve your trading.
To be more specific, learning how to master Blackjack requires you to think systematically, which is a skill that most traders don’t have.
For example, when a trader says he takes profit by “selling into strength”, that is not systematic. If a stock goes from $10 to $20, at what point during that rise is the precise sell signal?
With Blackjack as well as with Trend-Following trading, there is one and only one valid answer.
In the case of my strategy, I wait until price closes below the 20 day moving average and then exit the trade at market open the next day. Unlike “selling into strength”, this strategy has one and only one correct answer.
Similarly, each hand of Blackjack has one and only one correct solution. But determining that correct solution proved surprisingly difficult and it wasn’t until 200 years after the game first appeared in Europe that four U.S. Army engineers were able to mathematically solve it.
From there, in 1962, Edward Thorp, a mathematics professor, published the book "Beat the Dealer," which became a bestseller and a bible for Blackjack players. Thorp used an IBM 704 computer to simulate millions of hands of Blackjack, confirming and expanding on the U.S Army’s findings.
If the name Ed Thorp sounds familiar, it may be because he was featured in Jack Schwager’s must read book “Hedge Fund Market Wizards”.
In addition, Thorp wrote a book of his own which, incidentally, is also a wonderful audiobook read by the author himself:
Although the book covers many of Throp’s accomplishments - including inventing the Black-Scholes option pricing model and uncovering Bernie Madoff’s Ponzi scheme in the early 1990’s - let us re-focus on his first major accomplishment: popularizing Basic Blackjack strategy.
Despite being called “Basic Strategy”, it actually represents the most mathematically perfect way to play any given hand without counting cards.
Ed Thorp’s entire strategy is summarized below:
Because I’m a bit slow, it took me over a month to memorize the entire table, but once you learn the rules, you’ll be prepared to tackle any Blackjack hand systematically and without reservations.
Without a system, the average Blackjack player who plays using just his intuition will face a huge negative edge of around 5%; but with the strategy above, this shrinks to just -0.40%, which is a 92% improvement. Getting the edge positive does require some basic card counting, but I’ll save that topic for another day.
Before getting into card counting, one must first master the table above, so let’s go through an example.
Below is a good example of how human intuition can often lead you astray.
With a total of just 12, almost all players assume that it’s far too low and that he should hit in order to get closer to 21.
However, refer back to the table above and you’ll see that when the dealer is showing a 6, you should actually stand with a 12.
So human intuition says one thing, but your system says something else. Go with the system.
Here’s another tricky example:
With a total of 16, hitting seems awfully risky. Better not be greedy and stand, right?
Yet referring to the table below, there is one and only one optimal solution: hit.
Now when I once explained this strategy to a trader that I was teaching, he did in fact hit, but ended up busting. He then went on to claim that hitting was a “mistake”, and therein lies a major mental blockage that most new traders experience.
To be more specific, professional traders and gamblers evaluate the quality of a decision by the process used; amateurs, on the other hand, always judge a decision based on the outcome.
Although simple, this shift in mentality, first introduced to me by Michael Covel back in 2006, is a concept that even experienced traders fail to truly grasp.
For instance, I once tweeted about a stock breaking out of a base on huge volume that matched my buy criteria perfectly. Me and a German friend of mine at the time both bought the stock, but just a few hours later the company released some unexpected news and the stock plunged by 20%.
My friend was furious, calling my idea one of the worst trades of his life. Yet I still thought it was a good trade. Why? Because I judge a trade based on the information available at the time. When the trade was placed, I was following my strategy. I didn’t know that the company would release news a few hours later.
Despite trading for 20 years, my friend was still judging the trade solely based on the outcome, not the process.
Similarly, you’ve got to follow Basic Strategy and hit on a 16 even if it feels uncomfortable. Yes, you’ll probably bust, but it’s the least bad option available. And if you do bust, it’s not a mistake.
So you hit and you bust, or you follow your trading strategy and you get stopped out. Now what?