Probabilities

Hello Traders.

The probabilities side of trading is something I often see being misunderstood. Since probabilities are one of the very key foundations of trading, not understanding it can have a severe impact on your trading. It can lead traders to abandon perfectly good trading plans, and it can cause people to risk way too much.

There are no 100% strategies for trading. It doesn’t happen. If there were, then whoever commanded it would rule the market.

So what does that mean? Well, as traders, we want to find a win rate that is as close to 100% as possible without our losing trades becoming unmanageable. What I am talking about here are the systems that use things like a 500 points stop to make 20 points. They may have a 95% win rate, but the losses would easily decimate the account. The problem with these systems is that people can trade them for a year without those losses coming in, all the time believing they are successful traders.

But anyway, back to probabilities.

Let’s say we have a system that has a 70% win rate, and we average 1:1 on our trades over time. This is a profitable system and one you should be happy with.

But what does that 70% win rate mean?

‘’Well, it means that you’ll win 70% of the time.’’ Absolutely correct.

 But out of what sample size?

And this is where traders fall short and make mistakes.

It does NOT mean that for every 10 trades, 7 will be winners. That is not how it works and you need to understand this. Your sample size from back testing should be 100+ trades as a minimum. It should preferably be more. And out of all of those results, you find that you will come out with a 70% win rate.

So what happens in live trading?

One of two things:

1)   Traders get a run of winning trades – lets say 6. They start to think their system has become ‘higher probability’. They don’t click with the fact they are using a miniscule sample size. They increase risk… a string of losses come.

2)   They have a string of losses. They ditch the trading plan or worse, they increase risk, believing that their 4 losses in a row means it’s certain that a run of winning trades is coming.

Having a high win rate does not mean you can predict when the wins and when the losses will come. It does not mean that you can accurately predict how many trades out of ten will be winners. This is why professional traders risk very small amounts of their capital. They understand that the losses can come in extended runs.

I’m going to make a video for the YouTube channel on this subject in the coming weeks because I know it is something people struggle with.

As always, you want to protect your capital. Trading is first and foremost a defensive game. You want to do everything possible to assure you protect your capital.

Always trade as though a string of losses is coming. That way you’re always prepared for it and most importantly – protected from it.

I hope you all have a great trading week!