Having traded financial assets for decades, I have often pondered what proportion of trading outcomes can be attributed to luck rather than skill. The financial markets are a hybrid game in which the outcome is a function of both luck and skill. Decisions are made under conditions of uncertainty when establishing a trading position and when hedging or managing the position over time.
The first step in exploring the relative contribution of luck versus skill is identifying what we observe when luck or skill is exhibited in a given activity. In activities where luck is dominant, outcomes are more random and variable. Examples include tossing a pair of dice or spinning a roulette wheel.
In activities where skill is dominant, outcomes are predictable with a high degree of confidence. Examples include sports teams that consistently outperform their competition or high academic achievers who are consistently at the top of their class.
The question of luck versus skill is a topic of great interest when evaluating active investment management. Which fund managers have demonstrated skill over a given time period? The question is more nuanced than it first appears.
(More: Case for active management gets stronger every day)
Imagine a room with 1,000 people flipping coins. After each flip, those who flip tails leave the room. By about the 10th round, one person will be left who flipped only heads. Does this person have a special talent or coin flipping skill? When a large number of people are engaged in the same activity, there is a low probability that someone will attain an unlikely outcome. While that individual appears to be highly skilled, the outcome may be primarily or entirely driven by luck. To borrow the title from one of Nassim Nicholas Taleb's books, it is all too easy to be "
Fooled by Randomness."
In observing an outcome and determining where it lies on the luck-skill continuum, a baseline needs to be established. For options trading, that baseline can be the expected outcome based on chance alone. This is determined by calculating the probability of a trade being profitable. The probability can be calculated over the option expiration time period for any option strategy.
Comparing actual results to the baseline can reveal if the actual success frequency was below or above the predictions based on chance.
So far so good, but one issue jumps out right away.
As option traders know, it is possible to have profits from multiple winning trades vanish after a single losing trade. An obvious example is when writing out-of-the-money uncovered calls, the probability of winning is greater than 50%. However, sooner or later a significant loss is likely.
Consequently, skill cannot be measured by frequency of success alone. In fact frequency of success can be misleading. For option traders and investors in other financial assets, it's the overall profitability that matters.
(More: Why did active fund managers do a bad job picking stocks in 2014?)
NO MAGIC FORMULA
There is no magic formula for determining the relative contributions of luck and skill associated with options trading outcomes. However, the following criteria can be used to determine if skill has been demonstrated:
• A long time frame (many years) that includes a number of complete economic cycles as measured by gross domestic product. If profitability is achieved, it is likely that skill has been demonstrated across different market environments.
• A large number of trades (hundreds). It is less likely that a few lucky or unlucky trades will skew the aggregate results.
If profitability is achieved over longer time periods covering a greater number of trades, we can be more confident that skill has played an increasingly greater role relative to luck. Skill manifests over the long run whereas luck is more prevalent in the short run.
But we cannot discount the role of luck. No one has ever devised an options strategy that works 100% of the time. It is important to understand the scenarios under which a given strategy will fail. There is always at least one scenario that will result in a loss.
The more dependent an outcome is on luck, the more important it is to focus on the process. By consistently executing a logical rational process, a positive outcome is not guaranteed, but the probability of success increases. By actively increasing the probability of success we are able to achieve a more favorable trade-off between luck (what we can't control) and skill (what we can control) along the luck-skill continuum.
Meritt J. Finer is president of Matrix Investment Management.
