Wednesday, July 30, 2014

The Power Of Mathematics

There is an article Maths + Statistics = Great Beach Reading  on Bloomberg, which was discussing the good points of a book named "How not to be wrong". According to the article, the author of the book shows, the power of mathematical thinking and how mathematics and statistics help us understand the world better.

           Trading also depends on mathematics and statistics at great extent and directly affects the outcome. It  is widely used for calculating stops, targets and risk from a trade. Identifying risk from a particular trade is a much more necessary work for better trading and helps us to identify whether to enter in a trade or not, what is the risk/reward ratio in it and what are the odds of success of that trade.

          For example, suppose a stock rallied from 100 to 150, corrected to the level of 140 and bounce back from that level and touched level of 144. If we want to enter in that stock on the long side, then the risk/reward ratio will be 4/6 means we are risking 4 rupees for a reward of 6 rupees(and if the stock breakout from resistance then we can touch higher levels, so the reward could be even more). So this is a good trade, as we are risking less compared to reward and our risk is also pre-calculated and fixed.

         This is the most simple and fruitful use of mathematics in trading, otherwise it is also used for calculating and making every indicator also. Identifying risk earlier before entering into a trade is much more beneficiary for trader and helps to pick up the more fruitful and less risky trades.

2 comments:

Rajat Yadav said...

On the topic of odds. Read this in a book, there DOES exit a SECRET to trading. Lets try and prove it logically.

1) Odds for a move in either direction are never too high, if they were too high, a quick move will happen and odds will be back to 50-50 again. This means for most trades our probability is between 40-60%.

2) Now if the above statement is true and you only take profits at atleast 2 times the risk then nothing can stop you from being profitable.

3) If you take 100 trades assuming probability is on lower side - lets say 40%, assuming you risk 10000 rs per trade and take a reward strictly at 20000. Then on 60 losing trade gross loss will be 600000, and gross profit on 40 trades will be 800000. Thats a net profit of 200000 over 100 trades.

4) Adding breakeven stop and trailing stop will further improve profitability.

5) So basically, trade using any method, just focus on finding trades with 50% probability of reaching two times reward compared to risk will make you profitable, mathematics says so!

6) Once this step is mastered comes Kelly Criteria!

Raj Yadav said...

Tusi great ho ji