Probabilities In Trading
Think of trading in probabilities! This is one of the most used statements in trading education, the reason being it is true. But what does “think of trading in probabilities” mean? By the end of this article, you will have an understanding of how probabilities apply to the market and why focusing on the odds in trading will make you more profit.
Probability is the likelihood that a certain event or outcome will occur. In the markets, there is always a probability of a certain occurrence, our job as traders is to access this and make decisions in line with the odds. Starting off, what are the measurements of probability that we can use in trading?
Win % is simple, the percentage chance that a trader’s approach/ strategy will result in a positive outcome (profit). For example, if a trader implements breakout retests and 50 out of 100 trades are winning trades, the win % sits at 50%. Most people will think of a coin flip when probabilities are mentioned, by thinking of trades as a coin flip the concept of win % is easy to remember.
Imagine you have a coin that is weighted so it lands on heads 60% of the time, every flip has a 60% chance of landing on heads. Convert this to a strategy with a win % of 60%, every trade (coin flip) has a 60% chance of being a winning trade.
How much are you willing to lose when placing a trade? Risk is the potential loss that a trader accepts, it can be thought of on $, pips or percentage of account balance.
Reward refers to the potential profit that a trader may receive on a position, again it can be in $, pips or % of account balance.
Risk to reward ratio
Take the potential risk and the potential reward and compare put them against one another. A ratio greater than 1 means you expect to win more than you lose. Should a trade have a risk of 50 pips and a reward of 100 pips then the ratio would be 1:2.
How do these factors apply to trading?
A traders job is to access if the combination of the risk to reward ratio and the win % gives them a positive expectancy (edge). Wait a what? A positive expectancy, or edge, means over a large series of trades a trader will come out with a profit. Without an edge, it is impossible to make a profit so before all else a trader should have a strategy that has the potential to make money.
Here is a scenario. Say a strategy has a 55% win rate (loses 45% and a ratio of 1:2 (average loss is $1, average win is $2). After 100 trades we have 55 winners and 45 losers, the winners make $2 while the losers cost $1 each.
55 winners x $2= $110
45 losers x $1= $45
$110 – $45 = $65 profit
$65/100 trades= $6,5 profit per trade.
Using this simple calculation we can see that the strategy has a positive expectancy. Now that the basic components of trading probability have been discussed and we understand positive expectancy tome to move to what it means to think in probabilities.
What does it mean to think in probabilities?
1. Only trade if the probabilities are in your favor:
The basis of making money as a Forex trader is to have a positive expectancy, without this, a trader should not be putting money at risk because after a series of trades the net result will be a loss. Therefore step one is finding an approach that suits you and makes money.
2. Stick to your trading system
Once you have a positive expectancy, all that is required is the objective execution of the system. This is why trading psychology is vital to success. At this point, the edge of the system has been confirmed, so it’s about trusting in the probabilities and following the rules of your system.
3. Large sample sizes matter
Many a trader has failed due to a lack of understanding of this point. Accurate representation of a system’s performance can only be made after a large enough sample size i.e. many trades (follows the “law of large numbers”).
Why does this matter? Because it is easy to lose faith and stop following the rules of the system if the short-term results are poor e.g. if a trader has 5 losses in a row, this is emotionally taxing. This person will probably scramble to change a winning system or will not follow the rules of the approach, by doing this the expectancy of the system is no longer known or accurate.
Likely this will lead to a longer string of losses, the trader has dug themselves into a hole and may question if their system does not work. By thinking in probabilities thus remembering the law of large numbers, the individual can execute the system flawlessly because they know that even if there is a series of losses in a row, that in the long run the probabilities will balance out and they will be profitable. To make sure that you do not abandon a great system read this.
4. Trades are independent of one another
This relates to the previous point. Each trade that you place is independent from the last trade placed and the future trade. Therefore, a series of losses does not mean you are more likely to have a losing trader next and a series of wins does not mean you can predict that your next trade will be a winner.
Probabilities are “reset” with each new trade, similar to the coin flipping we mentioned earlier, every position entered (coin flip) has the same 60% probability and is an independent event. Keep this in mind to prevent thinking that you can predict what will happen.
5. Manage risk
Loses are a part of trading, nobody is a trading God so nobody can win all the time. Every approach will inevitably have a series of losses in a row, when that series of losses comes to an end there shouldn’t be a large dent in your trading capital or it will be difficult to recuperate those losses. That is why risk management is crucial to trading success.
Say that a trader has an edge but they risk 25% per trade, 3 losing trades in a row and suddenly there is only 25% of their capital left. When the probabilities even themselves out, the trader cannot make full use of the opportunities because they went all guns blazing and lost too much capital.
Losing traders worry about the outcome of the next trade. Winning traders trust in the probabilities, so they are only concerned about making money over 100+ trades. Don’t forget that.
Thinking in probabilities is the only way that a trader can weather the tough storms that the market throws at us. Keep a track of the objective performance of a system and remember the law of large numbers and you will have a far more successful, and peaceful, trading journey.
Trust the plan, trust the probabilities