Walk the Line, Part I

April 5, 2012
By

I keep a close watch on this [trade] of mine
I keep my eyes wide open all the time
I keep the ends out for the tie that binds
Because you’re mine, I walk the line…

- Johnny Cash, “Walk the Line”

To trade in the Mercenary style, there is a concept you should know about. It’s called the zero line.

What is the zero line?

  • In cash game poker, the zero line is the point at which your session is profitable. Above it, you have more chips than you started with. Below it, you have fewer.
  • In business, the zero line is your minimum profit threshold. Above the zero line, the business is turning enough profit to stay healthy and viable. Below it, trouble looms.
  • And in trading, the zero line is the point at which your entire portfolio – the sum of all actions — is profitable on the year. Above it, you’re in the black. Below it, red.

Those with a sharp eye will note I said “cash game poker” above, and not just “poker.” That’s because tournament poker is different.

Rising Tide

In tournament poker, the zero line is not fixed. It moves steadily higher as a function of blinds and the average stack.

Let’s say a poker tournament begins with 1,000 players, each with 10K in chips, for a total of 10,000,000 chips in play.

The average stack at this point is $10,000. A full day later, when half the field has busted out, there are still ten million chips in play – but now they are divided up among the remaining 500 players, for an average stack that has doubled in size from 10K to 20K.

In situations like this, it’s not good enough to stay “even” — you have to advance at a steady rate. If you aren’t keeping up with the average stack as blinds increase and the player pool shrinks, you are falling behind.

I mention this because business and money management can be like that too. The zero line is not always fixed – in a competitive environment, it can move. For investors, cost of living and inflation considerations act as a moving zero line too.

But let’s keep things simple here and go back to the fixed case. Why is the zero line such a useful and important trading concept?

For lack of a better term, it has to do with “life force.”

Use the Force Luke

Life is kind of a black-and-white concept. You are either alive or you are dead. But life force is more subtle. That is something that can wax and wane. When you are feeling healthy and powerful and invigorated, your life force is strong. When you are sick or tired or run down, your life force is weak.

The same idea applies to the health of a chip stack, a business, or a trading portfolio. It’s not quite as cut and dry as this, but there is a general relationship here:

  • Other things being equal, life force is correlated to distance from the zero line. The farther above the zero line, the stronger you are. The farther below it, the weaker you are.

To avoid confusion, I want to quickly address an old trader’s saying: “Losses make you strong; profits make you weak.”

That seems to be the opposite of what we just said – but it addresses something different. “Losses make you strong” is true in the sense that setbacks sharpen a trader’s mind and force a reclarification. “Profits make you weak” is true in the sense that large doses of success can invite hubris and complacency.

There is wisdom in that saying. But we are talking about something else here. The zero line concept is focused more on financial capital than mental capital, and proper stewardship of that capital for maximum long-term results.

Don’t Waste a Drop (Bip)

Mental capital is important, and a subject worthy of deep treatment elsewhere. But financial capital – i.e. your total dollars available for trading – is just as important.

As a trader, your financial capital is your inventory. It’s like oxygen to a scuba diver, jet fuel to a pilot, or ammunition to a sniper dug in behind enemy lines. You can’t afford to waste it or deplete it. You want to replenish it when you can and have plenty of reserves at all times.

Another way to think of it is like this: Whether your starting capital is five thousand dollars, fifty thousand dollars, or fifty million, in basis points (bips) it is always the same.

A basis point is 1/100th of a percent. So if you risk 100 bips on a trade, that is 1% of capital. Regardless of size, everybody gets 10,000 bips on January 1st. No more, no less. You want to add to your bips, not deplete them. If you can help it, you don’t want to waste even one.

The zero line — in conjunction with P&L expressed in basis points — is a simple way to monitor how your financial capital is doing.

Full Functionality

There is another concept from poker that may help explain the zero line’s importance.

A “fully functional” poker player is one who has full access to his strategic playbook. The fully functional player can play loose or tight as he chooses. All styles and tempos are available to him.

He can do things like run a multi-stage semi-bluff… push another player off a hand with the implied threat of future bets…  play highly speculative hands at exactly the right time… or carefully “massage the pot” with a concealed monster to win all his opponents’ chips on the river.

To do all of the above, though – to have access to the full playbook – our player must maintain a healthy chip stack.

As his chip stack becomes depleted by losses, this same player goes from “fully functional” to “marginally functional.”

As he keeps sliding, his status then drops from “impaired” to “severely impaired” to “desperate” (a place you never want to get to).

This happens because, as the chip stack diminishes, the cost of losses goes up — in both stack-percentage terms and psychological terms — even as the effectiveness of strategy goes down (because other players simply give less respect to a diminished stack, and show less fear in challenging you).

Don’t Let the Bastards Grind You Down

When you are ground down and short-stacked instead of healthy, you just don’t have the ammo or the table presence to make many of the nuanced, multi-stage moves you could have made before. Your options have grown limited. Down in the short-stack zone, you have to restrict yourself to basic, one-dimensional plays with rock-solid premium holdings.

The short stack has to pick his spots very carefully, and rely intently on the strength of the cards in his hand. It’s either that, or push all-in and pray for a good result. His other weapons have been taken from him.

In trading it works the same way: The farther you drop below the zero line, the more likely you are to see a transition status from “functional” to “impaired.” And the more impaired you are, the more that run-of-the-mill statistical outliers (like a string of unexpected losses) become a threat.

You don’t want the above to happen, if can avoid it. You want to maintain full functionality, and you do so through careful risk management and keen awareness of the zero line.

Ken Grant, risk manager to many of the top hedge funds in the world, talks about this as the “risk management investment.”

We’ll explore that further – along with what to do at, below, and above the zero line – next time.

JS (jack@mercenarytrader.com)


2 Responses to Walk the Line, Part I

  1. ClaudiusLSE on April 5, 2012 at 8:06 pm

    There is also a feedback loop present when moving towards or away form the zero point. This feedback loop is present in every biological system including your body (and yes, the market). It is not just a psychological boost to win – it actually causes your body to release more hormones that make winning more likely. The same is true for failure. The ace up our sleeve we have as humans is the ability to step outside of our failures and examine them. However, it is much easier to submit to the downward spiral of failure than to keep a level head and climb back on top. But it is possible. We are limited in controlling our emotions, but we are not limited in how we react to them.

    • Jack Sparrow on April 8, 2012 at 11:23 am

      Agree, though the same feedback loop can be dangerous if it turns to hubris — as always, and like risk vs reward, a balance…

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