Compounding Yield in Sports Trading

Compounding, the magic ingredient that will give us untold wealth. We've all done it when we started out trading. We opened up a spreadsheet and took our first day's yield and compounded it over the next few years. "I'm going to be a millionaire!" we foolishly say to ourselves.

I still run a compounding spreadsheet but not for sports trading. My bank accounts and other regular forms of income are noted each week and a compounded value for the next five years is calculated. This makes sense because a bank account (no matter how little they pay these days), peer2peer and other investments can be more relied upon than sports trading income.

I expect to make 10% per year on my portfolio of investments and other incomes and so I expect to double the value of my portfolio in 8 years time. Why can I not do the same for sports trading? The answer is market capacity.

Just because you are making 10% yield on your trades now does not mean to say that you will continue to yield 10% as your bankroll increases thus allowing you to make bigger trades. There is only a finite amount of money on offer in the exchange.

Compounding your winnings is a similar fallacy to using the Martingale to recoup losses. In Martingale betting, a naive gambler playing roulette thinks they can just double their bet after a loss to get their money back. However, the casino has a maximum bet limit and if you have a run of bad luck then your bet doubling will exceed the table maximum and you'll never get your money back.

To control risk a casino sets a limit as to how much money is in play at roulette. The same applies to market capacity only natural forces determine how much money is in play at any one time. Keep on winning and eventually you will hit the market limit as your bet size increases.

In the case of a naive sports trader, they might imagine there will always be enough money to cover their trades. However, the amount of money available at a given price is always finite. If you want a larger trade then either you have to accept a worse price or you will have to put your own offers into the market to get people to take the opposing view. The danger with that is that you have now become the market and if you are wrong about the price then you will lose edge.

And that's the problem you will have with compounding in sports trading. You are in a money market of finite size with agents who are also trying to maximise their wealth creation opportunities. In early market trading there is not much money in the market. Put too much in and you are the market. Make a mistake and someone with better knowledge (an insider) will destroy your edge. Nearer the start of a horse race or during an in-play sport there will be more money available but time is now at a premium where bad decision making can ruin your wealth.

Even though I recommend proportional and Kelly based money management strategies they usually have to be toned down to allow for noise and combining that with market capacity means that the hoped for geometric growth sometimes turns out to be little better than linear growth. I have created Kelly simulations on a spreadsheet and the rate of increase is astonishing but never realistic. There just isn't enough money in the exchange after a few wins.

You can be almost sure of returns from bank accounts, less risky investments and employment income. That is not the case with higher risk investments and sports trading. Compounding of sports trading income in a market of limited cash and limited opportunity is a fallacy. The successful trader will increase their wealth rapidly at first, if they are any good, but after that growth becomes more linear.