Tuesday, April 22, 2014

Probability Is The Cornerstone Of Trading

       No one can predict the future with certainty. Neither I, nor you, nor the top traders in the world can tell you what the market will do in the next minute, hour, day or week. Traders have to operate in an environment of uncertainty.

How then do traders make money in the market ?
The asnwer is: probability.

       Consider a trader who trades only head and shoulder patterns. His research tells him that 5 out of 10 patterns will be profitable. He makes 100 points on each profitable pattern, while he restricts his loss to 50 points on each failed pattern. In the long run, he will make 250 points for every 10 patterns he trades in. Based on the past research, the trader has a strong probability of making profits if he consistently trades these head and shoulder patterns.

       Will the trader make money on each trade ? NO. He will make money on a series of trades because in the long run, probability is in his favor.

       Suppose you ask the trader to tell you what his next trade will be. Then you take that trade. Will you make money ? Not necessary. What the trader is doing is to take 10 trades by which time probability should ensure that he makes a net profit. Thus, asking a successful trader for 'Tips' may still cause you to lose money while the trader remains successful.

       Success in trading is far more dependent upon the understanding, acceptance and application of probability principles than any other factor.


Rajat Yadav said...

I posted exactly the same thing on a chat box today, just copying it here.

An observation on - Safe vs Risky calls

1) Lot of calls that are given are in the format " Risky call- short nifty/stock/banknifty" , "Risky traders hold, safe traders exit"

2) Risky itself has no meaning- All calls should be given two parameters- a) Probability of success b) Risk Reward

3) If probability of trade going in your favor is 50-50 & Risk Reward greater than 1:1 then over long run you will make money.

4) If probability of trade going in your favor is less than 30%, then reward to risk should be greater than 3:1 to make profit over long run.

5) if you are a very good scalper and can identify 70% probability trades, you can do well over a long run with your reward smaller than your risk.

5) Usually people who give "risky calls" , which I am assuming have a probability of less than 40% , also tend to exit early with a risk reward equal to or less than 1, over a long run this approach will lose money.

Rajat Yadav said...

The same reason beginners looking to short in uptrend and buy in downtrend rarely make money.

Probability of trend reversing reversal is very less. Even if a reversal works out, it is emotionally hard to hold till a reward that is much greater than risk to compensate for low probability.

Failure by math.