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Know When to Play

February 8, 2007

In a game of Texas Hold’em, each player receives two cards initially. Then the betting begins. After that round, the dealer uncovers a set of three cards. These cards, called the flop, are available for use by all players to create the strongest possible hand. Then another round of betting commences. Next, for all who decide to stay in the game, a single card—the turn—is uncovered. This, too, is available to all players. After yet another round of betting, the final communal card—the river—is turned over. At that point, there is a showdown and the strongest hand takes the pot.

One of the cardinal skills of Texas Hold’em is the decision of when to play and not play. Do you fold, do you call, or do you raise? All you see initially are the two pocket cards. You have no idea of the cards held by the other players or the cards you might be able to use from the flop, turn, and river. All you can do is try to assess your odds and the competition. The player who has done his research knows that, in an eight hour poker game where 35 games per hour are played, the number of times he will be dealt an unsuited Ace, King will average between three and four. Those are rare, good pocket cards and you have to play them. Conversely, a low, nonconsecutive, unsuited hand gives little in the way of odds and, in a game with ten other strong players, you would be wise to fold and wait for something better.

Traders face the same question of when to play. If they are trading frequently on an intraday basis, they want volatility—even if there is no dominant trend. Good intraday swings provide a number of opportunities to make money on the long and short side. Conversely, low volatility days will meander in a tight range for hours at a time. Even if your timing is good enough to catch a swing within the tight range, the accumulated commissions over the day can eat you up.

To address the issue of when to play, I looked at the Spiders (SPY), which closely mimic the S&P emini futures. I selected the period from September, 2002 to the present (8/27/04), which included 493 trading days, and I calculated the correlation between the day’s volume and the day’s range. Note that, in calculating the range, I am examining the difference between the highest and lowest points actually traded during the day—not the day’s price change (which could be a function of overnight trading). The day’s range is a particularly relevant measure of volatility for the intraday trader. Interestingly, the correlation was a highly significant .605. Stated in other terms, about 36% of a day’s volatility is accounted for by the day’s volume.

That provides us with a potential edge. After the market opens, you—the trader—are dealt two pocket cards. All you see is what the market has done during the initial period of trading. You have to decide whether you fold or bet. As the trading game progresses, the next time periods provide you with the flop. Once again, you decide that the day is offering you a great hand—and you eventually go all in—or that you’ll bet more modestly or not at all. Still later, in the afternoon, the market reveals the turn and river and decide how, if at all, you’ll stay in the game. By looking at the volume of the market hand you’ve drawn, you can make some inferences about that market’s volatility. If the overnight Globex session has shown unusually high volume and volatility, I can look for a wider range in early morning trading. If the morning trade—my pocket cards—shows little volume, I have little reason to expect a wide-range trending movement in the midday (when volume and volatility tend to be lowest in general).

Just as in poker, the market player updates estimates of odds with each new "card" that is revealed. Is volume and volatility, relative to recent historic averages, growing or shrinking? Is it historically low, average, or high? Is there enough movement here to make me want to play the game?

The professional poker player Ken Warren advises, "The important thing to remember is that your goal is not to play hands of poker, but to make the best decisions hand in and hand out. You’re playing to win money, not to play cards, as paradoxical as that sounds". Similarly, your goal as a trader is to make money, not to trade. If the market is not providing you with tradable swings, do you want to be in the game? The really good poker players—and traders—know not only how to play, but when not to play.

There is one important difference, however, between poker and trading. In poker, you can draw a 72 and bluff the table, betting aggressively and making others think that you’ve drawn the nuts. Other players might even capitulate and cede the pot to you. In trading, unless you trade enough size to move the market, there is no bluffing when the opening period provides a narrow range on low volume. If you go all in, betting on a breakout move, there is a good likelihood that you’ll be revisiting the opposite side of the trading range before that breakout ever occurs. Those are the situations that separate traders who want to trade from those who need to trade.
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