Trading Is About Probabilities – You Know That Right?

Trading is  a game of probability for traders and any successful trader knows that at any time, the next trade can be a winner or it can be a loser.

Trading with an edge, you want to allow the probabilities to play out and that can only happen over a large basket of trades which means, you must stay in the game for a long period of time.

Losing trades are always going to happen and short of not trading at all, there is nothing you can do to prevent a losing trade from happening.

What you can do is limit the impact of every losing trade even though you don’t know which trade will be the one to go against you.

Do You Fully Grasp The Probabilities In Your Trading?

The trouble is that although I believe people do understand the general concept of probabilities in trading, they often do not really ‘get’ it or apply it to their trading. What I mean by this is that people understand that over a set of historical data X% have been winners and Y% have been losers.

But all too frequently it stops there, without the trader fully exploring the implications of those numbers that are found when they back test their trading system.

Your trading strategy can be simple or it can be complex and I’m not saying that there’s a right or a wrong way to trade, just that there’s a minimum level of understanding of various principles you need to have to be a long term profitable trader.

There are two main ideas related to trading probabilities which I feel are important to take on board:

1. Historical win:loss ratios are not definitive measures of future probabilities. They are merely predictive indications of future probabilities.
2. When you have an idea of what a setup’s win:loss ratio will be, you still cannot know whether the next trade you take will be a winner or a loser.

The idea of probabilities in trading can be slightly misleading if we’re not careful. It suggests that going forward, a strategy will have a certain percentage of winners and losers, but in reality it doesn’t necessarily always work like that.

It should be clear that markets are always changing, sometimes drastically and sometimes more subtly. In either case the future performance of a trading strategy will be different, better or worse, than its historical performance.

Embrace Knowing What You Don’t Know

You must also ask yourself whether the historical performance being used to predict the future performance is likely to be useful to the current market conditions. For example, if you were to use performance from several years when the market was trending and it’s currently moving sideways, do you really believe it’s likely to be an accurate representation of near-term future performance?

Probably not.

Following on from this idea, are you taking account of changes to market conditions as they happen?

The second aspect to tackle is the fact that you cannot know whether the outcome of the next trade you take will be or won’t be favorable.  A strong historical win:loss ratio may lull you into a false sense of security with an individual trade, but the truth of the matter is, the next trade can be a profitable trade or hit your stop loss.

You don’t know for certain what the odds are on the next trade (act as if you trade like a casino) even if you have an overall idea.

For example in a set of 250 trades, you might have a win:loss ratio of 1.5 meaning 60% are winning trades. But that means that 100 trades have been losers. What if 8 trades in a sequence of 10 were losers?

A 20% win rate doesn’t sound so great does it?

But that can happen.

This is why it’s so important to clearly define your risk parameters for each trading setup and stick to them religiously. It’s also why some traders choose to have a personal circuit-breaker rule where they are only willing to take a certain number of losing trades in a row.

At Netpicks, we call this the Power Of Quitting.

The Power Of Quitting refers to a time, usually for day traders, where they will stop trading during the course of a session.  The reasons can be varied such as:

• • The best time window to trade has come to a close
  • Taking a certain number of trades and stopping when positive on the session regardless of the overall profit
  • Taking a certain amount of losing trades in a row and calling it quits

Capital management and deployment are perhaps as important as the strategy itself over the long run. The trouble is that the human mind can be drawn to what’s in front of it, especially when it’s the emotional side doing the thinking – not uncommon when a trade you strongly believe in is in a losing position.

Therefore the idea that the specific trade is part of a larger set of trades is quickly forgotten…….

1. So you give the trade just a little more room.
2. Then a little more just to be sure you don’t get stopped out on an otherwise fantastic trade.
3. Then you notice you’re in a big hole.

I know it’s frustrating that sometimes you will get stopped out to the tick before it reverses and shows you a full profit target, but sometimes that will happen.

Sometimes you’ll close a trade exactly where it turns and heads in a straight line to your stop price.

I would point out that I’m not suggesting that win:loss ratios or statistics in general are not useful but it’s how we use them which can lead to us to becoming unstuck. Statistics don’t lie; they simply are what they are.

Humans misinterpret or manipulate their meanings in order to support their own ideas which is why the psychology of trading is vital to understand.

The Market You Trade Has The Final Say

Whatever we think we know will happen, the market often has other ideas. If we fail to respect the uncertain nature of the markets, we are not trading mindfully, and we don’t prepare and act when things do not happen as we believe they will, we’re probably not going to last in this business.

When I start thinking I know what is going to happen it’s an excellent indicator for me to take a mental step back and reassess my views.

The only certainty in the markets is that I know that I don’t know and I am comfortable with that.