Thursday, 2 July 2015

Understanding That Trading is all about Probabilities

Probabilities. If you’ve delved into any trading literature, you will have read the phrase, ‘trading is a probabilities business.’

The problem is, not many people understand the true extent of that statement. A lot of people think they do, but they don’t.

Trading is based around probabilities. This means that no matter how good you are, how flawless your system is, you CANNOT be right 100% of the time.

Still sounds pretty simple, right? But let’s delve a little deeper - A lot of very successful traders have a win ratio of only 50%. You tend to find that the average is around 70%. This means, that of every 100 trades you take, 30 will be wrong. There is no escaping it; you can’t ‘work harder’ to fix it. That’s probabilities at play, my friend.

The problem? We are raised in a society where failure is seen as a bad thing and avoided at any cost. It is ingrained in us in our very nature from the time of our ancestors – fail to identify a predator and you die. Our modern day equivalent? Fail your exams and you fail at life, you wont get a good job, you wont be able to afford the things you like.

And in trading? You NEED to fail. Those failing trades are all part of the business. 70% success rate means that on occasion you will have 2 failing trades in a row. 3 maybe. 4 can happen. You never know when they’ll come or how many there will be.

Taking failing trades never becomes easy. But if you want to be a successful trader you need to avoid the herd mentality, which is that of avoidance. The majority of ‘traders’ find a system, see some good results and get confident. They think they’ve cracked it and start flicking through car magazines and imagining the bank vault filled with money. And then the losses come. One isn’t so bad, they expected that. No system is perfect, after all. The second one isn’t nice. They wonder if they have done something wrong. They check their entry, their system, but it all looks ok. Then the third loss: they panic. This stupid system doesn’t work any more, it’s eating all of their money. Lucky they spotted it in time!
What next? New system. Always a new system. Rinse and repeat. This continues until they blow their account or they outright give up.

Last month one of my trading systems failed three times in a row. It has never done that before. It felt horrible and self-doubt crept in. What did I do? I kept trading it! Why? Because I have extensively back-tested the system. I don’t mean using an automatic back-testing programme or gazing at a few days of charts. I tested the system every day on the charts for well over a year worth of data. Every trigger point I noted the profit or loss of each trade and at the end I discovered it was a profitable system.

This is KEY. You need to back-test to get comfortable with probability. Only proper, in depth testing will allow you to ignore your ‘survival instinct’ when the losses come rolling in.

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