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Bull Spread In the 7th Race



So far we've covered the battle of the racetrack fundamentalists vs. the technicians, and value investing. Today, in this final installment from Saratoga Springs we're going to take things to the next level.

Now, some people prefer plain vanilla positions, while others like things to be a bit more exotic. Oh relax, I'm talking about their betting strategies. I am an exotics player and rarely place straight win bets unless I like a horse that is 10-1 or more.

Straight win bets are like long-only stock positions that are all-or-nothing propositions. If you buy a win ticket on your horse, then the horse must finish first or you get nothing. A slightly hedged approach is to bet your horse to win, place, and show. If your horse finishes third you will lose your win and place bet, but at least get a small amount of your money back.

Exotics wagers, though, are like the options market of the racetrack. The basic exotics wagers are the exacta, where you pick the first and second place finishers in order; the trifecta, where you pick the first, second, and third place finishers in order; and the superfecta, where you must pick the first four finishers in correct order. Because these wagers are more difficult to predict, the potential reward is much greater, corresponding of course to the increased risk. They also give you some degree of leverage since the payouts compensate for the higher degree of risk. A $2 win bet on a 20-1 longshot will return $42. A $2 straight exacta that selects a 20-1 shot over an even money favorite may return as much as $160. Leverage.

Like options strategies, exotics wagers can be as simple or as complex as you like. Let's look at some examples using the trifecta. Remember, a straight $2 trifecta requires you to select the top three finishers in exact order. This bet is inexpensive, and features the potential for great reward, but is very risky since it offers absolutely no margin for error. Your selections must finish in order, or you get nothing.

A more complex trifecta bet is a $2 trifecta box where the three horses you select can finish in the top three in any order. This may seem like a good idea at first, but with a trifecta box you've simply increased the number of your bets from one to six since you're simply covering all six potential combinations that include the three horses you've picked. This, of course, requires more capital outlay. A straight trifecta, one bet, will cost $2. There is only one way to win with a straight trifecta. A trifecta box is six different bets covering all possible combinations of finish with the three horses you've chosen. The cost, therefore, is $12.

You options fans may have already noticed the real problem with the trifecta box bet: it weights equally all possible combinations. If you believe the three horses you've selected all have an equal chance of wining the race, and all three horses are going off at overlaid odds, then that's not a problem. In reality, however, it is rare that you will find three horses in the same race with an equal chance of winning. If you do, there's likely something wrong with your methodology.

The answer to this weighting problem, similar to common methods of portfolio management, is to choose a core position and then trade around it to mitigate near-term directional risk.

I know that you're thinking this is quite a stretch of our analogy, but bear with me and follow this closely. I don't think it makes financial sense to bet multiple exotics combinations that equally weight all potential outcomes. To solve this problem I focus on selecting a core position, called a key horse, and then trade around this core position with other horses who I believe have the potential to disrupt things. This reduces the total cost of the bet, allows me to use more than three horses when I need to, and places the bulk of the weighting where I want it to be, on my key horse.

This bet is called a trifecta part wheel. With this bet, I'll typically use my key horse on all trifecta tickets in first, second and third. I then choose other horses with which to trade around this key horse. As long as my key finishes in first, second, or third, and two of the other horses I select land in the other two money spots, then I will cash the ticket.

This is what it looks like in its simplest form:
$2 trifecta part wheel where 1 is the key horse.

1, 2-3-4, 2-3-4 = 1 must win and 2, 3, or 4 must finish in second and third for $12.
2-3-4, 1, 2-3-4 = 1 must finish second and 2, 3, or 4 must finish in first or third for $12.
2-3-4, 2-3-4, 1 = 1 must finish third and 2, 3, or 4 must finish first or second for $12

Of course, this is a simplified part wheel. I'm not limited to using only 2, 3, or 4. I can vary the horses, add more horses in the third spot, etc. As I mentioned, exotics strategies, like options strategies, can be as simple or as complex as you like.

In the world of options equivalency, you may have already noticed that this is really nothing more than a synthetic win, place and show bet on my key horse with some leverage built in. Since I'm a weekend player, and an inveterate longshot bettor at that, I look for homeruns not singles, so this fits my style.

In some respects, an individual race can also be looked at as similar to, say, a sector index. "Whoa", what?!? Stay with me. A typical race may have anywhere from 6-12 starters, or components. Given my style, to me the most attractive betting situation at the track is when the public chooses a "false" favorite, or a horse at very low odds, that my methodology suggests has a dramatically lower chance of winning the race than the public estimates.

Similarly, a powerful combination for an equity trader may arise when she believes a particular component in a given sector index is likely to seriously underperform the other components in the index. (For ease of argument we'll assume this is an equal-weighted index in this overly simplified example). One way to profit from this thesis is to go long the index, and strip out the weak stock by selling it short. If the thesis proves correct, the short will make money and add some juice to the positive movement of the index.

At the track, this same phenomenon can be especially lucrative if the favored horse finishes out of the money. Exotics combinations that include favorites typically pay at underlaid odds because the public overemphasizes the favorite in their own exotics wagers. By selecting a key horse in this situation, and then including the other potential combinations that exclude the favored horse, I can effectively strip the horse out of the index and profit at overlaid odds if the favored horse finishes out of the money.

And you thought betting on the horses was strictly for cigar-chomping retirees with white shoes! Oh, it's still possible to have a nice day at the track betting on the colors of the jockey silks. It's just that I prefer my entertainment to be a bit more thought-provoking than that. Enjoy your day and I'll see everyone back tomorrow.

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