Trading Probabilities

When I first started out in trading, many moons ago, it was made clear to me and my fellow trainees that one of the most important concepts to grasp is that successful traders tend to think in terms of trading probabilities. The trouble is and this was obvious by the rate of attrition, most of my colleagues either didn’t get this or didn’t even attempt to address it.

An Edge is Historical

So the thing to really think about here is the nature of an edge. I’m not talking about the technical specifics of an edge – I’m talking about what it gives you in terms of trading advantage.

Simply put, an edge is a higher probability of a certain outcome over another, given a certain set of circumstances on a historical set of trades.

Note the all-important historical basis. This means that the market has behaved in a certain way in the past and therefore the edge does nothing more than indicate the chances of it happening again in the future. The markets are ever-evolving and so you cannot ever rely on a trade working forever.

Every Trade is Different

The fact that markets are always changing also gives rise to the idea that no single trade is the same. What the market has done prior to the setup will impact upon it. Which market participants are currently present and active will also have an effect. No trade is ever precisely the same even if it looks like another – so the assumption has to be that the outcome may well be different.

You Just Don’t Know

As much as humans are pattern recognition machines and at times can get a really good feel for what’s happening in the market, you just don’t know what will happen next. For example, a massive fund might enter the market and need to sell a gazillion contracts when you’re in a long position. The same fund might have a trader who “fat fingers” (fat finger = the act of accidentally inputting a trade incorrectly – sometimes placing a much larger trade than intended) and price might move sharply against you. Or even a piece of news might come out that has a dramatic impact on prices.

None of these things is predictable in nature and so whatever the market and your trade looks like, you just don’t know for certain how it will turn out.

Edges Consist of Multiple Trades

Going back to the definition of an edge, you’ll note that I say over a historical set of trades. The implication is that an edge won’t necessarily play out over a single or even small number of trades whatever the outcome – it requires many trades to be taken to get close to the historical win rate The outcome of a single trade is either a winner or a loser and it’s not something you either want or even need to predict.

Take the probability of heads on the flip of a coin as an example. Over 10 trades you might get 5 heads, but it’s just as conceivable that you get 3 heads, 7 heads or even 0 heads. Now if you went on to flip the coin 100 or 1000 times, the rate of heads you’ll achieve will most likely come closer and closer to the theoretical odds of a head.

The same principle applies for casinos. They know that the odds are in their favor and for those odds to play out, they need to keep taking your bets over and over and over again. So a big winner can actually help them by encouraging more bets.

If a setup fulfills the criteria of your edge, how do you know if it will fall into the winning or losing category? If you knew it would be a loser, why would you even bother taking it?

Trading Probabilities

We’ve established that there are plenty of uncertainties in trading and because of this, it’s important to not only think but also trade in terms of probabilities. In order to do so, it’s absolutely crucial to know exactly what your edge is and what needs to happen in order for you to take or exit the trade. By making things as unambiguous as possible, you are able to replicate your own actions given certain observations in an otherwise imperfect market – or at the very least, you know what you should be doing.

Taking a winner or a loser on a single trade should be almost irrelevant when trading probabilities.

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