Rock Paper Scissors - A Trading Analogy!

Sometimes you hear something and you have to do a double take, or a double listen. This is one of those times. I've know Lance Beggs from YourTradingCoach.com for a while and he sent me an email last week with 'Rock Paper Scissors - A Trading Analogy' as the title. I was hooked so replied, he got back to me with his short explanation, and I quickly told him to write it down in article form for the Trader's Blog members to enjoy...so please do and feel free to ask Lance any questions in the comment section.

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Yeah... I'm serious!

Rock Paper Scissors!

I know all the other trading educators are talking about poker and the lessons it provides in position sizing and trader psychology. I'd love to sound really cool as well and talk about No-Limit Hold 'em, or Aces over Kings, or all manner of other great-sounding terms. But the fact is that I don't know the first thing about poker. And I figure I'm not the only one.

So, here's one for all of us non-poker nerds... a game that everyone should know, which also provides an excellent lesson for traders.

If you're not familiar with Rock Paper Scissors, check out Wikipedia or the World RPS Society website. That's right... there is a worldwide body dedicated to the promotion of this game, the standardization of its rules and to overseeing the annual International World Championships.

Essentially, Rock Paper Scissors is a game that is widely used for decision making or solving disputes. Two players simultaneously deliver a hand signal representing either a rock (clenched fist), scissors (as per rock, but with the index and middle finger extended representing the two blades of a pair of scissors) or paper (open palm facing down).

Rock breaks scissors.

Scissors cut paper.

Paper covers rock.

Typically, in an informal setting the winner will be determined by the best out of three throws, although you may from time to time see a single throw, sudden-death game. If you aspire to attending the World RPS championships, the winner is determined by the best out of three sets, each set being won by the best out of three throws.

If you're confused, don't worry - personal Rock Paper Scissors trainers are available.

So, how does Rock Paper Scissors relate to trading?

Let's first examine the nature of the game. On the surface the result of each game appears to be random. Basically a coin toss, but with three outcomes instead of two - win, lose or draw. On closer examination though you'll recognize that the reality is much different. Unlike a coin toss, the outcome of each game depends on decisions made by the human participants.

And human decision making is NEVER random, particularly when there are high stakes involved.

Your decision about whether to throw rock, paper or scissors, will largely be influenced by your beliefs about your competitors decision. If you know what they're likely to throw, you'll adjust your throw to ensure it beats their choice.

A great example of this is the following exchange between Lisa and Bart in The Simpsons episode #9F16.

Lisa:              "Look, there's only one way to settle this.  Rock Paper Scissors."
Lisa's thought:     "Poor predictable Bart.  Always takes rock."
Bart's thought:     "Good old rock.  Nothing beats that."
Bart's throw:          Rock
Lisa's throw:          Paper
Bart:              "D'oh!"

The result in this example is far from random. Lisa has managed to win the game through awareness of her opponent's belief systems.

In fact, there appears to be a little bit of Bart Simpson in all of us.

The World RPS Society reports statistics from a number of Rock Paper Scissors sources. The one providing the largest sample comes from the Roshambull application on Facebook, which at the time of reporting had logged over 10 million throws from over 1.6 million games. Statistics in this sample show Rock being thrown 36% of the time as opposed to paper 30% and scissors 34%. It appears that rock is more often the number one choice of Rock Paper Scissors competitors.

If you doubt that psychology plays such a great role in Rock Paper Scissors, schedule a high stakes game against a family member or friend. Something harmless of course, but high stakes - maybe the loser has to wash the winner’s car each fortnight for the next 12 months. You'll find that your throws are not random at all, but rather you're trying desperately to anticipate your opponents move, exploiting any knowledge you have about the way your opponent thinks.

Before you schedule this game though, let's have a quick look at how you can gain an edge at Rock Paper Scissors.

Firstly, we know from the above studies that the distribution is skewed slightly in favor of rock. So, if we're playing against a novice, the initial edge is available through throwing paper, as paper covers rock. It's a very slight edge, but it's still an edge.

Of course, the strategy will have to change against someone with a little more experience, or in fact anyone who recognizes the non-random nature of the game. These people will be expecting that we'll throw paper, in order to beat their 'obvious' rock. As a result, they're more likely to throw scissors in an attempt to beat our paper. So, instead of paper, we'll throw rock to beat their scissors.

It's all about staying one step ahead of your opponents thought processes.

There's more... watch out for two throws in a row of the same type. People are very wary of being too predictable. If your competitor has produced two throws in a row exactly the same, their next throw is statistically more likely to differ. As an example, let's say they've had two rocks in a row. Not wanting to be too predictable, they'll most likely throw either paper or scissors on the third throw. So, your choice should be scissors, as it'll win against their paper, or draw against their scissors.

Another great option is to suggest a throw to your opponent. Imagine your reaction if we were competing and I said to you, "It's so easy to read you - your next throw is going to be paper." Subconsciously I've implanted in you a desire to avoid paper. You don't want to be predictable, so you'll be more likely to throw either rock or scissors. This makes my choice easier. The edge for me is in throwing rock as it will beat your scissors, or worst-case tie against your rock.

The opposite of this is to state your own intentions before throwing. I could for example say "I'm going to smash you on this final one. Get ready for my rock." The last thing you'd expect now is for me to actually be so stupid as to throw a rock. So you'd be expecting me to throw paper or scissors, leading to your likely choice being scissors in order to get a win or draw. So, I simply give the throw I mentioned - rock - beating your scissors.

Love it!

Of course, it's not all that simple. The World RPS Society website has a strategy guide for sale if you're interested in exploring this further. Remember though, you are playing against humans. Not only are their decisions not random, but they're also often irrational. So, although you might have an edge, you're still playing over a very small sample of games. Be sure to never bet what you can't afford to lose.

So, how is this a trading analogy?

Novices mistakenly think that Rock Paper Scissors is a game of chance.

As we've seen though, Rock Paper Scissors is actually a game of skill and strategy in which success comes from being able to read your opponent, adapting your game to profit from their likely actions. Success is not guaranteed in any particular throw, but if you can successfully get within the mind of your opponent you'll gain an edge which will see you to victory over a series of throws.

Likewise with trading...

Some novices believe it's a game of fundamentals. They'll study the company reports, PE ratios, dividend yields, or wider economic factors such as the retail sales or payroll figures. They aim to find a stock or instrument which is valued differently from what they believe is its true fundamental value. They'll then enter expecting the fundamental factors to push price to their perceived 'correct' value.

Other novices believe it's a game of technicals. They'll use indicators, which are simply a derivative of price, in an attempt to predict future price movement. As price moves in a particular direction the indicators will follow, eventually triggering our novice trader into the market. There is rarely any thought as to what caused the initial price movement, or whether or not the context of the current market supports continued price movement. They operate simply on hope that the price movement which triggered them into the trade will continue in the same direction.

In fact, neither is correct. Trading is not a game of fundamental or technical analysis.

Like Rock Paper Scissors, trading is a game of understanding people and how they make decisions.

True, your competitor is not one individual. Rather, you trade against the collective market which is made up of millions of other traders and investors all making individual buy and sell decisions.

Price moves in response to the net order flow that results from all these individual buy and sell decisions. If the net order flow is bullish, price will rise. If the net order flow is bearish, price will fall. It's as simple as that. The fundamentals don't move price. They technicals don't move price. Order flow moves price.

So, the game of trading is one of identifying those areas where a significant number of traders are going to feel compelled to take action and then entering before they enter. It doesn't matter whether you use fundamentals or technicals or any other form of analysis. If you can achieve this on a consistent basis, you've got yourself an edge.

Know what other traders are thinking - and you can position yourself to profit from their actions.

There are numerous ways of achieving this. A simple example is the use of chart pattern failures. The more obvious the chart pattern, the better. A technically perfect head and shoulders pattern will produce a large order flow short as price breaks the neckline. But should that pattern fail there will be an even greater order flow long, as the bears scramble to cover their losses. Knowing how traders will act at the point of pattern failure, I can position myself to enter long at this point, to exploit the increase in bullish order flow.

So, examine your trading approach. Whether it's based on fundamental or technical or quantitative or astrological or any other means of analysis, ensure you consider the fact that the market exists because traders make trading decisions. It's not about the technicals or fundamentals. It's about knowing what your competitor is thinking.

Like Rock Paper Scissors, if you know the likely decisions and actions of your competitor, you'll know how to position yourself for a higher probability of success.

Lance Beggs
YourTradingCoach.com