TRADING IS A PROBABILITY BASED BUSINESS

"The world is an uncertain, even random, place. What “should happen” might be totally clear, meaning we know what the future should hold. But the things that should happen may not happen – and other things may happen instead – for any of a variety of reasons, many of them extraneous, unpredictable and even nonsensical. Those things can be described as random: the result of luck, either good or bad."

~ Nassim Nicholas Taleb, Fooled by Randomness

 

Trading is a matter of Probabilities.

  • Any trading strategy, no matter how effective, will be wrong a certain percentage of the time.

  • Traders often confuse the concepts of Winning and Losing traders with Good and Bad trade. A Good Trade can Lose money, and a Bad Trade can Make money​​​

Accept Future is Unknowable

Lao Tzu observed "Those who have knowledge don't predict. Those who predict don't have knowledge." 

  • In Investing/ Trading, it’s hard to know what will happen and impossible to know when it will happen. Many things influence performance other than (a) investors’ hard work and skill and (b) the market’s dependable discounting of information about the future. Luck – Randomness, or the occurrence of things beyond our knowledge and control – plays a huge part in outcomes.        

  • In many ways, life is one long poker game. Sometimes you win, sometimes you lose. All we can do is learn to be comfortable with Uncertainty and keep making good bets.

  • There is always uncertainty. Investment is about taking on and managing uncertainty. At best, around 50% of our investments work out and about 20% of them will produce approx. 80% of the gains. The trick is to keep the good investments and quickly unwind the ones that do not work out.

  • Nobody can tell us what is going to happen. What we should do is to forget predicting the future and to manage the condition of the markets as we find it now

Risk vs. Volatility vs. Uncertainty

  • Why should we care about the distinctions between Risk and Uncertainty? The main reason is that investing/trading is fundamentally an exercise in Probability. Everyday, investors must translate investment opportunities into probabilities. So we need to think carefully about How we come up with Probabilities for various situations and Where the potential pitfalls lie.

  • You need to think about the Future in terms of Possibilities and Probabilities rather than in terms of Prediction. Trading is filled with Uncertainties. You do not know whether a trade is going to make money. The best you can do is be confident that the rewards will outweigh the risks over the long run.

  • Elroy Dimson:“Risk means more things can happen than will happen.” In other words, the future isn’t a predetermined scenario that’s sure to unfold, but rather a range of possibilities, any one of which may happen. Investors formulate opinions as to which of them will happen. Those opinions may be well-reasoned or dart throws. But even the most rigorously derived view of the future is far from sure to be right. Many other things may happen instead.

  • Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don't know what the underlying distribution looks like. So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain.         

  • Risk always includes the notion of Loss, while something can be Uncertain but might not include the chance of loss.

  • Finance theory defines risk very precisely as volatility. It's my view that academicians settled on volatility as the proxy for risk as a matter of convenience. I just don't think Volatility is the risk most investors care about. There are many kinds of risk...but volatility may be the least relevant of them all. Rather than volatility, I think people decline to make investments primarily because they're worried about a Loss of Capital or Unacceptably Low return. I'm sure "Risk" is - first and foremost - the likelihood of Losing money. The possibility of Permanent Loss is the Risk I worry about.

 

Edge / Expectancy

  • We never knew which trade would end up being a winner and which a loser. We just knew the general shape of the distribution of possible outcomes we might encounter. We thought that each trade possibly could be a winner but that most probably would be losers. But ultimately, we knew that the winners would be large enough to cover the losses from the losing trades and that there would be profit left over.

  • The statistical term for EDGE is EXPECTANCY which shows the EXPECTED VALUE of a system/ strategy

  • Expectancy =( %Winners x $/Winner) - (%Losers x $/Loser)

    • A +ve Expectancy means that you have an EDGE in the market. You can expect to make money over a large number of trades

    • A zero Expectancy means you have No EDGE

    • A -ve Expectancy means you have a -ve EDGE. You can expect to lose money over a large number of trades

  • FREQUENCY combines with EXPECTANCY to give you the true value of your trading system/ strategy. All things being equal, if you have 2 strategies with the same Expectancies, the one with the higher Frequency of trades will make you more money

  • You can only realize the Expectancy of a strategy by employing correct POSITION SIZING. This means that you’ll only achieve the expected results of a good strategy if you can stay in the game long enough for the probabilities to play out. You can make hundreds of mistakes in your market reads, strategy, and execution, but if you have correct position sizing (and discipline in exiting your losing trades quickly), you will survive. You will survive long enough to build your skills and become profitable

  • Understanding basic PROBABILITIES is key to understanding trading edge. As a trader, you have to focus on the long-term, and not on the results of any specific trade. Just focus on the correct process, and if you’ve built a good strategy with solid money management, the odds will play out in your favor in the long run and you will make money.

  • Accuracy and the reward-to-risk profile combine to give you edge in trading. 

  • Edge, is the Expectation of how much money you’ll make over a large enough number of trades.

 

Position Size

  • You have to train yourself to trade at a smaller Size so that you trade within your Emotional capacity 

  • It is the SIZE of the position you put on rather than the PRICE at which you put it on that determines your ability to keep the position. The larger the position, the greater the danger that trading decisions will be driven by FEAR rather than by JUDGMENT and EXPERIENCE. One way of knowing your position is too large is if you wake up thinking about it

  • You have to trade at a Size such that if you're not exactly right in your Timing, you won't be blown out of your position

  • My approach is to build to a larger size as the market is going my way. I do the same thing getting out of positions. I start to lighten up as I see the Fundamentals or Price Action changing

  • Scaling type of approach in entering and exiting positions has enabled me to stay with LT winners much longer. You have to be able to let your profits run

  • POSITION SIZE is important not only in avoiding trading too large, but also in trading larger when warranted. If everything lines up in a trade, then the trade should be put on in larger than normal size

  • Traders need to adjust position size in response to the changing market environment. If market VOLATILITY increases dramatically, traders need to reduce their normal exposure levels correspondingly, or else their risk will dramatically increase

 

Cutting Losses

  • The reason why so few traders produce consistent results is simply because they haven't mastered the dynamics behind what it means to keep the average loss of their losing trades much smaller than the average profits of their winning trades.

  • Understand and respect market realities that anything can happen at any time,  great traders realize that you can never truly predict anything in the market (you can just put the odds generally in your favor over a large number of trades). They realize that it only takes one major player to come off the sidelines and change the whole picture instantly. They realize that the markets can become ‘irrational’ and that they can stay irrational far longer than we as traders can stay liquid if we let our losses get larger

  • Understand probabilities and learn to think in these terms, you realize that it’s not about any given trade and whether it’s a winner or a loser. Rather, it’s about your overall edge or expectancy. So it’s about thinking in terms of a long series of trades and their overall outcome, with losing trades being a natural part of that long series of trades.

  • The losing trades are already factored into your strategy’s expectancy, so there’s no reason to actively avoid them. Instead, you take each trade realizing that sometimes it’ll work and sometimes it won’t, and since you can’t predict which one will or won’t, you just execute all of them with discipline and take your losses quickly with discipline knowing that this is the other way (the first being correct position sizing) to realize the expectancy of your system or
    strategy.

  • When you accept risk and losses, you realize that being ‘wrong’ is okay and just a part of a
    probabilistic game
    , and you understand that losses don’t mean you’re a failure, and you know that you can afford losses, and you’re not overconfident about your market reads, and you don’t try to avoid losses. i.e. You overcome the obstacles to being disciplined about cutting losses and not having excessively large losers.

  • The practical way to be disciplined with losses is to:

    • Always use stop-loss orders on every single trade

    • Never revise your stop-loss while in a trade unless that revision decreases or keeps the
      risk constant