Trading - A Probability Game
As a trader, you have to forget about finding a sure thing. You
must accept the fact that the stock market can do anything at
anytime. If you are not convinced, consider that there are
millions of traders trading for institutions, funds, investors,
swing traders, scalpers, etc... all acting together in different
time frames and using different types of analysis.
Fact: Trading is not about guessing the future because it cannot
be done.
If you accept this fact, then it is much easier to take losses
without destroying your self-esteem. You take a trade, you
accept that you don't know what will happen next. You have no
expectations that this trade will turn into a winner. Your only
expectation is that something will happen.
So how do you make money not knowing what will happen next? You
treat trading as a probability game. Here is an example of a
probability game:
Let's say I roll a dice:
- I pay $1 each time I play - If I roll a 3, a 4, a 5, or a 6
then I win $2. If I roll a 1 or a 2 then I don't win anything.
Clearly, every time I roll the dice I have no idea what the
outcome will be. But I know that for every roll the odds are in
my favor. In the long run, I will win 4 times out of 6, which
means that I will pay $6 to win $8. I will be a consistent
winner if I play long enough.
In mathematical terms, your expected win each time you play is
(4/6) X $2 = $1.33 meaning $0.33 profit (you pay $1 to play)
Another version of this game could be that you win $3 if you
roll a 4, a 5, or a 6, and nothing if you roll a 1, a 2, or a 3.
In this case the expectation each time you play would be
(3/6) X $3 = $1.50 meaning $0.50 profit in the long run
So how do we translate this into trading?
Each time you roll the dice, you don't know the outcome, the
same as for each individual trade. But each time you roll the
dice, you know the odds are in your favor to make money, and you
will make money if you play long enough.
So for each trade you enter, you must know that the odds are in
your favor to make money. As you can see in the second example,
it does not mean that you have to win more often that you lose.
It also depends on how much you win when you win and how much
you lose when you lose.
How do you put the odds in your favor?
You have to develop a trading edge using technical analysis,
fundamental analysis, market internals, etc.. You have to have a
number of variables that must be present before you enter a
trade and always use the same set of variables. Your edge is
your strategy to enter and exit trades and should be well
defined in your trading plan.
All that can be summarized as follows:
- For each trade you take, you don't know the outcome, you
accept that anything can happen, and therefore you have no
expectation for that trade.
- You believe in your trading strategy, that is you believe that
for each trade you take the odds are in your favor.
- You believe that the outcome over a series of trades is
relatively certain and predictable.
To go back to the dice example: will you get mad or feel stupid
when you don't roll a winning number? No because with a dice you
accept the fact that you cannot know the outcome. You have no
expectation. Apply the same idea to your trades and save your
self-esteem.
This idea of treating trading as a probability game made a big
difference in the way I feel about losses. I learned about it in
"Trading in the Zone" by Mark Douglas. I strongly recommend this
book.
If you have a good trading plan, with a strategy to enter and
exit trades, then a successful trade is one for which you
followed your plan, not necessarily a winning trade.
And remember, you will never know if your strategy works if you
don't follow it.