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Behavioral Finance, Racetrack Betting and 

Options and Futures Trading

William T. Ziemba

Alumni Professor of Financial Modeling and Stochastic Optimization
Sauder School of Business
University of British Columbia, Vancouver, Canada

Mathematical Finance Seminar
Stanford University
January 30, 2004
Investing in traditional financial markets has many parallels with racetrack & lottery 
• Behavioral anomalies such as the favorite­longshot bias are pervasive and also exist and 
are exploitable in the S&P500 and FTSE100 futures and equity puts and calls options 
• Biases there favor buying high probability favorites and selling low probability 
• In complex  exotic wagers such as the Pick 6, the bias is to overbet the favorite so one 
must include other value wagers in the betting program.
•  Information such as breeding is important and is useful for the Kentucky Derby and 
Belmont Stakes.  
• Lotteries have a possible advantage from the unpopular numbers, which have 
substantial advantages but low probability of success on each play and a long time to 
have high confidence of success. So the optimal bets are very tiny.
• Futures trading in the turn of the year effect and some racing bets can have both a high 
expected return and a high chance of success so the optimal bets very are large and are 
tempered by risk control considerations.
Main points to learn from this lecture
• Means are by far the most important aspect of any portfolio problem.
• You must have the mean right to have good performance.
• If you have the mean right and do not overbet you should do well.
• In levered bets, it’s the left tail that can lead to trouble so you must not overbet or you can
have a large disaster occurring without warning.
• Behavioral and other anomalies can yield strategies that have positive means.
• Studies of racetrack bias date at least to the late 1940s
• These biases yield ideas that yield profitable positive mean strategies in racing, sports
betting and options markets.
• The capital growth or Kelly criterion strategy yields the most wealth in the long run and
dominates all other essentially different strategies.
• But in the short run, the expected log criterion with its essentially zero Arrow-Pratt risk
aversion index is very risky and can have substantial losses.
• The most you should ever bet is the log optimal amount; betting more is suboptimal and
betting double yields a zero growth rate.
• Negative power utility, which blends cash with the expected log maximizing portfolio
provides more security but has less long run growth.
• These fractional Kelly strategies are attractive for many investment situations;
determination of what fraction to use depends on constrained optimization models.
If you bet on a horse, that’s gambling.
If you bet you can make three spades, that’s entertainment.
If you bet cotton will go up three points, that’s business.

See the difference?

Blackie Sherrod

Unbridled at Claiborne Farms,

Paris, Kentucky
Effect of data input errors on portfolio performance
Mean Percentage Cash Equivalent Loss Due to Errors in Inputs


Conclusion: spend your money getting

good mean estimates and use historical
variances and covariances
Reference: Chopra and Ziemba (1993),
Journal of Portfolio Management, reprinted
in Ziemba-Mulvey (1998) Worldwide asset
and liability management, Cambridge
University Press

Results similar in multiple period models and

the sensitivity is especially high in
continuous time models. See examples in
AIMR, 2003.

• market in miniature

• fundamental and technical systems

• returns and odds are determined by

1) participants -- like stock market, unlike roulette
2) transaction costs -- track take (17%), breakage

• bet to
1) win -- must be 1st
2) place -- must be 1st or 2nd
3) show -- must be 1st, 2nd or 3rd
Win market

• n horses
• Wi = public’s win bet on horse i=1,…,n
• W = ΣWi = public’s win pool
• Q = track’s payback fraction (≈83%)

Return on horse i =

QW/Wi if horse i is 1st

0 otherwise
How do you calculate actual returns on win bets

Experiment: do bettors like high odds horses or low odds horses?

• Low odds horses are the best ones, high odds horses are the worst ones.
• Would you rather bet on a 2 to 5 shot and receive 40% profit if you win or a 20 to 1 shot where
you receive 2000% profit if you win?
• The public prefers the latter but the expected returns are much higher for the favorites.

• The favorite-longshot bias has persisted for more than the last half century.
Running up sand dunes - it is difficult to win at the races

Typical behavior of the betting

fortune of the average bettor

Probability of being even or

ahead for the typical win
bettor in California
Favorite­Longshot bias at racetracks and in other gambling events

• Behavioral finance
Kahneman-Tversky (1979)
low probability events are overestimated
high probability events are underestimated
• More bragging rights from picking longshots than from favorites
50-1 wow, was I smart
2-5 easy pick
• Transactions costs
bet $50 to win $10 it’s hardly worth the effort
• a 1-10 horse having more than a 90% chance of winning has an expected value of
about $1.03 (for every $1 bet)
• a 100-1 horse has only has an expected value of about 14 cents per dollar invested.
The fair odds are about 700-1 not 100-1.
• Early literature goes back to at least 1949
US, British, Asian, etc papers reprinted in Hausch, Lo and Ziemba (1994), Efficiency of
racetrack betting markets (Academic Press) Out of print, Amazon/eBay have had originals
at high prices; I have low price copies available. Contact me at for any of
my racing, lotto and investment books and research papers.
• Updated in Hausch and Ziemba (2004) Handbook of Sports and Lotto Investments, North
Griffith 1949 study - 1386 races in 1947, Churchill Downs, Belmont and Hialeah
1934 data similar

Number of entries, winners and winners times odds for every odds group
Odds (subjective) vs percent winners (objective)
Reprinted in HLZ (1994)
Favorite-longshot bias at racetrack and in other gambling events

The effective track payback

less breakage for various
odds levels in California and
New York, more than
300,000 races over various
years and tracks, Ziemba
and Hausch (1986) Betting at
the Racetrack.
Ziemba (1994) and
The bookies know about this.
Expected return per dollar bet with and without the track take deducted for different
odds levels in the Kentucky Derby 1903-1986 and in 35,285 races run during 1947-
1975, from data in Snyder (1978)

The better races have flatter biases; see references in Tompkins, Ziemba and
Hodges (2003) The favorite/longshot bias in S&P500 and FTSE100 index futures
options: the return to bets and the cost of insurance.
Has the bias in the US changed with rebates and betting exchanges? Yes.
It seems to be more flat.
Data for essentially all North American races for the last 7+ years, about 2 million
horses in about 300,000 races.
We have a good data set: essentially all of the S&P500 futures puts and calls, all years, all strikes.
Do the buyers of puts and calls on the Stock Index options behave like racetrack bettors?

Who buys and sells them

• At the racetrack there are only buyers, but there are sellers on betting exchanges. In options, futures
and stock markets there are buyers and sellers.
• Demand for options come from both hedging needs and speculative investing (gambling).
• Hedge funds are active shorters in purely speculative ways or in complex hedging strategies.
• For the put options the primary use of options is for hedging, and only on a secondary basis is the
demand for speculative investing.
• Hedging demand for puts implies that the expected return is negative and more so for deep out of the
money options; cost of insurance.
• For the call options, the most obvious hedging demand is for those selling call options against existing
holdings of equity.
• This strategy would tend to depress the price of (especially out-of-the-money) call options.
• If this were the sole mechanism for dealing in call options, this should result in an increase in the
expected return for out-of-the-money call options, which we do not observe.
• Much more likely is that the expected loss from the purchase of out-of-the-money call options is due to
some speculative activity that appears to be similar to that for long-shot horse race bets.

• We have a good data set: essentially all of the S&P500 futures puts and calls, all years, all strikes from
1985 current.
• Monthly and Quarterly data was used instead of daily data to ensure independence of
observations and final outcomes.
• We used all expiration dates (March, June, September, and December) for the quarterly
expiration cycle and all the available monthly expirations (e.g. January options on a March
• We recorded the final settlement price of the futures on the expiration of the option contracts, the
futures contract with exactly three months to expiration and all available one-month and three-
month option prices on the futures contract.
• For the first date in the analysis, the current expiring futures contract was not used and for the
final data point, we examined the final futures price in September 2002.
• All options prices traded at the minimum level at the relevant market or allowed a butterfly
arbitrage were excluded [see
• Jackwerth and Rubinstein (1996)]. The interest rate inputs were obtained from the British
Bankers Association (US Dollar or British Pound LIBOR).
• With seventeen years of quarterly data, we had 68 observations and an average of 39.1
available strike prices per observation for the options on the S&P 500, 69 observations with an
average of 30.8 available strike prices for the options on the FTSE 100, and 60 observations with
an average of 17.8 available strike prices for the options on the British Pound / US Dollar.
• With seventeen years of monthly data, we had 187 observations and an average of 39.0
available strike prices per observation for the options on the S&P 500 and 124 observations with
an average of 28.6 available strike prices per observation for the options on the FTSE 100.

• To obtain results comparable with horseracing which also aggregates into categories,,
we aggregated the initial odds [N(d2) and N(-d2)] into bands of 5%.
• We pooled all the options in these twenty ranges and averaged the outcomes for the
same 1$ initial investment.

What would we expect?
• When risk premium exist (for example in equity markets), the expected return for the
investment in options will differ from the $1 investment.
• We examined call and put options using the Black Scholes (1973) formula with no risk
premium and risk premia of 2%, 4% and 6%.
• This is done by inputting –2%, -4% and –6%, as the continuous dividend rate [using the
Merton (1973) dividend adjustment] in the Black Scholes formula.
• The ratio of the option prices are determined and plotted as a function of the moneyness.
• The calls lie above the $1 investment and the puts lie below the $1 investment.
• Note: 1.0 is deep in the money and 0.0 is deep out of the money
Average return per dollar bet vs. odds levels: 3-month stock index calls, 1985-2002

• The favorite deep in the money calls have positive expected value like the favorites at the
• The longshots used for covered calls and other strategies in high demand have large expected
• Deep out calls have low expected value; 1.23 cents per dollar for .00 to .05.
• The shape is broadly similar to the racetrack graphs
Average return per dollar bet vs. odds levels: 1-month stock index calls, 1985-2002

1 Month Stock Index Futures Call Options

Wealth Relatives








1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

• The call advantage is gone; they all break even.

• The deep outs still have low expected values.
All puts lose, the cost of insurance is high.

This is essentially all the data on the S&P500 futures options; the graph is smooth with a few
Possible peso effect: you are paying for an event that has not yet occurred but could occur.
But this data includes October 1987, October 1989 and 2000-2002 crashes, so has a lot in it
With more data, the graph is smoother.
Trading ideas and the results of one hedged strategy

You sell the options with negative expected value and buy those with positive expected value and
have various levels of hedging using S&P500 futures.
20 years of actual trading with real money and extensive simulation and other research suggests
which ones and when to sell/buy/hedge in the various strategies to provide good, steady gains with
minimal risk.

• Bias strategy in various forms.

• Hedged currencies
• Positive mean
• Optimal betting
• Risk control - must protect against extreme events, bad scenarios
Reference: W. T. Ziemba (December 2003) Stochastic Programming approach to
Asset-Liability and Wealth Management, AIMR, text plus separate appendix.
The results of one hedged strategy (simulation)

• The geometric mean is about 45% net for top graph which uses a short term
overpriced market indicator to eliminate five deemed risky of the 70 plays; you win
in 60 of 65.
• The bottom graph has all 70 plays, including the Oct 1987 crash and July 2002
which the measure eliminated.
Tests with real money in two small futures accounts of WTZ

Jan 2002 to present Oct 2003 to present

• Long euro, long canadian hedged also in this account

• Mean > 0 in my view weak dollar
• Small positions to weather storms, still results very good
• Watch entry and exit and rollups carefully
Place market in horseracing

Inefficiencies are possible since:

1) more complex wager

2) prob(horse places) > prob(horse wins) ==> favorites may be good bets

To investigate place bets we need:

1) determine place payoffs

2) their likelihood
3) expected place payoffs

4) betting strategy, if expected payoffs are positive

Bettors do not like place and show bets.

The Idea

1. Use data in a simple market (win) to generate probabilities of outcomes

2. Then use those in a complex market (place and show) to find positive expectation
3. Then bet on them following the capital growth theory to maximize long run wealth

Breiman (1961)

lim wealth log investorT
® ¥
T ® ¥ wealth any other essentially different investorT

So in the long run, the log utility investor dominates.

Growth versus security

Security rises if the bet sizes are decreased with fractional Kelly (negative power)
but growth decreases as well. Half Kelly is -w-1.
Fractional Kelly f=1/1-α, α<0, in αwα is exact for lognormal, approx otherwise. See
MacLean-Ziemba, Time to Wealth (2002).
Half Kelly is half the Kelly wager plus cash.
Right graph has dosage filter; do not bet on horses that cannot run 1 1/4 miles on
the first Saturday in May.
Horses with high dosage cannot really win the Kentucky Derby or Belmont Stakes

Dosage  =  

See Bain, Hausch and Ziemba (2004) An application of expert information to

win betting on the Kentucky Derby, 1981-2001; merging of prices (odds) with
expert opinion (breeding measured by dosage).
Some Kelly bettors: Keynes, Buffett, Thorp and Benter

The first two are “stock market” people and are closer to full Kelly. See text in AIMR, 2003.

Keynes: Graph of the performance of the Chest Growth of assets, various high performing
Fund, 1927-1945 in AIMR, 2003 funds in AIMR, 2003

See Thorp (1998) for analysis showing Buffett is close to full Kelly.
Buffett’s Sharpe is below Ford’s but if you delete upside, it’s better, see AIMR, 2003.
Thorp and Benter - the “gamblers” like smooth wealth paths using fractional Kelly.

Princeton Newport Partners, L.P., Cumulative Hong Kong racing syndicate to 1994, see
Results, November 1968-December 1988 in Benter’s paper in Hausch, Lo, Ziemba (1994)
AIMR, 2003
Does it work? Update a terrific, smooth record.

Hong Kong racing syndicate to about 2001.

You can have 700 independent bets all with a 14% advantage and still lose 98% of your fortune
Half Kelly loses a lot of the growth much of the time in exchange for a smoother wealth path.

Probability of doubling and

quadrupling before halving and
relative growth rates versus fraction of
wealth wagered for Blackjack (2%
advantage, p=0.51 and q=0.49

Betting more than the Kelly bet is non-optimal as risk increases and growth decreases;
betting double the Kelly leads to a growth rate of zero plus the riskfree asset.
LTCM was at this level or more, see AIMR, 2003.
What is the optimal fractional Kelly?

• MacLean, Sanegre, Zhao and I, JEDC (2004) solve this in a continuous time model
where you check discretely and use a Var type criterion on the wealth path.
• With Kelly, the better the bet is the more you bet and thus the more you lose when you
lose so it’s very hard to stay above a wealth path.
• Theory developed under restrictive assumptions; calculations: algorithm exists but
computations lengthy.
Guide to Capital Growth Theory and Kelly Criterion Literature

1956 Kelly heuristic paper, original idea (Latane, 1957, also)

1961 Breiman, original correct proofs
1969 Thorp original application to sports betting
1981 Hausch-Ziemba-Rubinstein, application to place and show system, books later Ð
1984, 86, 87
1988 Algoet and Cover most general proofs
1994 Hausch-Lo-Ziemba reprints many key articles
1995 Hakansson & Ziemba survey finance view point in Finance Handbook, reviews
HakanssonÕ s work
1998 Janacek MSc Thesis, Charles Univ. creative student
1998 Thorp brilliant math analysis
1999 MacLean-Ziemba, fractional Kelly examples (series of papers 1986+)
2002* MacLean-Ziemba theory of targets rather than time, Time to Wealth
2003 Ziemba AIMR, more simply written, many references
2004 MacLean-Ziemba et al how to calculate the ÒoptimalÓfractional Kelly;
controversial constrained optimization, JEDC
Place/Show system in theory - the place payoff

Pi = public’s place bet on i=1,…n

P = ΣPi
If i and j are the first two horses, gross return/dollar bet on i to place is:

(QP - Pi - P j) 1
2 Pi
Si = public’s show bet on i=1,…n, S = ΣSi
If i, j and k are the first 3 horses, gross return/dollar bet on i to show is:

(QS - Si − Sj − Sk ) 1
3 Si
Hausch, Ziemba, Rubinstein (1981) Management Science and Ziemba-Hausch books.
Academic papers in 1994 Academic Press.
Toteboard and place payoffs

1  2  3 4 5 6 7 Total
Odds 4-5 13-1 6-1 5-2 16-1 11-1 33-1  
Win 8293 1009 2116 4212 885 1251 457 18223
Place 2560 660 1386 2610 696 903 339 9214
1570 495 1860 1881 543 712 287 6558

If horses 2 and 3 are the first two horses, the gross payoff/dollar bet to place on horse
2 is:
((.83)(9214) - 660 - 1386) 1
+ 1 = $4.24
2 660
$4.20 (with breakage) returned for each $1 place bet on i.
Place probability

Let qij = probability i is first and j is second Efficient win market gives
qi = Wi/W.
Harville (1973) proposed:  place probabilities
determined using just
qij = prob(i first)•prob(j first if i not entered) = qi • public’s win odds.

Similarly, probability i first, j second, and k third is

qi q j q k
qijk =
(1 - qi)(1 - qi - q j)

There are biases in these formulas; see HLZ (1994) - they are ok for this system though as the
biases tend to cancel.
Expected place payoff

Expected gross return on a $1 bet to place on horse i =

qi q j qi q j QP - Pi - P j
Σ j=1,...,n, j≠i ( + )( + 1)
(1 - qi ) (1 - q j) 2 Pi

Probability i and j are 1st & Place payoff on i if i & j are 1st &
2nd in either order 2nd in either order
Optimal capital growth model

If a wager has a positive expected return, how much should be wagered?

Assume a sequence of independent wagers with the following return per $1 wagered:

{ r

w.p. q

w.p. 1-q

If rq>1, what is the optimal fraction of wealth to invest each period?

Optimal capital growth model (Kelly 1956, Breiman 1961, Algoet and Cover, 1988)

The expected rate of growth of wealth from wagering fraction f of wealth each
period for n periods is:
1/ n n
R( f ,n) = [q(1+ fr) 1/ n
+ (1- q)(1- f ) ]

lim R( f ,n) = (1+ fr) ×(1- f ) q 1- q

q ln(1+ fr ) + (1− q ) ln(1− f )
Therefore, maximizing the asymptotic expected rate of growth is achieved by
myopic use of a logarithmic utility function, i.e.,

max q ln(1 + fr ) + (1 − q ) ln(1 − f )

With one wager, the optimal fraction to bet is f*=edge/odds=p-q.
Slew O’ Gold, 1984 Breeders
Cup Classic
f*=64% for place/show; suggests
fractional Kelly.
Optimal capital growth model, assumes our bet influences the odds and we
can bet on multiple horses.

Non concave program but it seems to converge.

Exhibition Park, 1978, typical returns.
Aqueduct, 1981-82
Summary Statistics on Dr Z System Bets
Expected value approximation equations

æw i /w ö
Ex Place i = 0.319 + 0.559ç ÷
è i ø/ p

æw i / w ö
Ex Show i = 0.543 + 0.369ç ÷
è i ø/ s

• Notice expected value (and optimal wager) are functions of only four
numbers - the totals and the horse in question.
• These equations approximate the full optimized optimal growth model.
• Solving the complex NLP: too much work and too much data for most
• This is used in the calculators.
1983 Kentucky Derby
1991 Breeders’ Cup Race 5
Fractional Kelly place and show bets on the Kentucky Derby


30000 0.1
20000 0.4
Wealth 0.5
10000 0.7



• Axis is max % of wealth you can invest with full Kelly, Unconstrained you bet far too much..
• Effect of Arazi in 1992: one race as a 3-year-old, knee operation risky bet.
• Suggests low Kelly fraction. He lost.
• No horse has ever won the Kentucky Derby with just one 3-year-old race and very few with
two races.
• As a 2-year-old, Arazi was absolutely brilliant.
Does the system still work in 2004?
Yes, it looks pretty good. Bets made with one minute to go.

• Huge amounts of money come in with a lag from the rebate shops at the buzzer.
• Still the old system does well.
• Odds of favorite tend to fall at buzzer and that helps us.
Special case - sub-bet
• Favorites are usually underbet to win; this is useful in situations like the place and show 
systems.  These are high probability low payoff situations. 
• However, the situation is reversed in low probability high payoff situations. 
• Then favorites are overbet because in exotics there are usually multiple races or 
multiple horses or both so that many tickets are needed to have a good chance of 
• Most bettors pick the favorites and overbet them so their tickets are not too expensive.
• Then they are most likely not to win and if they win, they get very little because they 
have picked the favorite so the payoff is very low.
• This was the behavioral key.
• Filigree, the third choice in the morning line went off at 8-1.
• The 3rd and 5th races back, he ran faster than the favorite Love at Noon ran in
his last two races. So he had a chance to win and he did.
• Love at Noon went off at 1-5 and had most of the P5 money
Top number is final speed number, other numbers are pace within the race.
Approximate Kelly with more money on higher probability wagers.