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Me, A Value Investor?



Welcome back to Saratoga. Yesterday we talked about the links between securities analysis and handicapping horseracing. Today we're going to take it a step further and talk about "value" betting.

I'm a "value" handicapper. In other words, I look for horses that are under-appreciated by the betting public, and are therefore going off at odds higher than what their true chance of winning suggests. Sounds easy, right?

Consider, for example, a horse whose odds are 2-1. Odds of 2-1 mean the public believes that if the race were run 10 times, the horse would win 33% of those races. Suppose, however, that you believe the horse's true chances of winning should be, say, 50%, or expressed in track odds, 1-1. In other words, you believe the public is underestimating the horse's true chances of winning the race. Using the standard $2 betting unit as an example, the horse, if it wins, should return $2 on your $2 bet for a total of $4, but because the public has underestimated the horse's true chance of wining, a $2 wager will actually return $6. That is what is called an overlay: a horse whose true chance of winning is underestimated by the public. An underlay is a horse whose true chance of winning is overestimated by the public.

That is the concept of value at the track. As you can see, it's not much different from the stock market. At the risk of oversimplifying things, value investors buy stocks that they believe are undervalued by the investing public. Value handicappers bet on horses that they believe are undervalued by the betting public.

Identifying underlays and overlays is necessary in order to reach a judgment on risk versus reward. To add a slight twist to things, there's also the magnitude of the risk/reward calculation that must be taken into consideration. Traders must be keenly aware of the risk/reward relationship of their positions at all times. The best handicappers approach the races the same way.

There are traders who play by the tick, and as short-term day-trippers they wouldn't dream of spending more than a few hours in a position. There are also position traders who couldn't care less about the minute-to-minute ticks and instead focus on moves of a greater magnitude.

For the professional horseracing bettor who is at the track every day, an overlay is an overlay is an overlay. It doesn't make a lot of difference if the overlay in the race is 2-1 or 20-1. As a weekend player, however, I am uninterested in an overlay for the sake of an overlay. Instead, I focus more on identifying underlays that I can bet against, or overlays going off at pretty big odds. The reason for this is that being a weekend player with a day job, I have the luxury of not being forced to bet dollars to win nickels. The guy who makes his living at the track doesn't always have that luxury. The same goes for the short-term trader. If the market is giving you ticks, you don't always have the luxury of sitting things out and waiting for points. You have to take what the market gives you.

Below is a standard odds line with the odds on the left and the percentage of winning to which those odds correspond. The only way to determine if the horse you like is an overlay or an underlay is to construct your own odds line.

In order to construct your own odds line, simply assign the percentage chance of winning to each horse in the race based on your own beliefs. The total of your odds line must equal 100%. The first difference you may notice between your personal odds line, and the morning line odds in your program, is that the morning line odds do not total 100%. The total SHOULD be 100% of course since there is a 100% chance, and only a 100% chance, that one horse will win the race. The track odds maker is burdened with the task of not only making a line that he believes will correspond to the way the public bets the race, but also with attracting capital into the betting pools. You may notice that morning line odds typically total around 120-125%. The extra 20-25% accounts for track takeout, about 17%, and breakage. When you factor in the takeout, you are down 17-20% as soon as you place a bet, win or lose.

Of course, personal odds lines are subjective, but constructing one helps you avoid betting on underlays. As you can see, with a track takeout of 17%, you are down significantly before the race is even run. If you bet on horses who are going off at odds that overestimate their chance of winning then you further compound the uphill battle you are already fighting from the onset, and the race hasn't even been run yet! If betting on horses is ultimately a path to the poor house, then betting on underlays is the quickest route there.

Tomorrow we'll look at plain vanilla strategies versus more exotic hedging and swap strategies. No, I'm not talking about options or derivatives. I truly believe you can learn as much at the racetrack about the concept of hedging positions and managing risk as you can from the run-of-the-mill options textbook. In the meantime, I'll be at Hattie's Chicken Shack on Phila St. enjoying the best Southern fried chicken North of the Mason Dixon line.

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No positions in stocks mentioned.

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