PROBABILITY IS KEY

Suppose I have a system that each month provides 60% of winners where for each trade, using a liability of 250, I aim for a profit target of 500. Note I am operating an example here where the risk per trade is 2.5% assuming a bank of 10,000. (so small trading amounts in highly liquid markets)

If I trade 60 times per month then

Number of winners (60%) = 36
Number of losers (40%) = 24

Income = 36 x 500 = 18,000
Losses = 24 x 250 = 6000

Net profit = 18,000 - 6000 = 12,000

Obviously this will depend on whether you are able to identify 60 high probability trades per month (and whether you have a model which has an edge of 60% whilst maintaining a 2:1 reward/risk ratio) and you also need to take into account other factors such as broker/exchange fees, slippage and risk management measures such as portfolio risk for the day/week. But the basic core of probability is simply this model.

Standard deviation changes would mean that some months you might make 14,000 another month 10,000, another month, 20,000 etc but over the course of a year you would be averaging close to 12,000 per month if all the trading parameters were constant.

It was this simple and basic understanding of math and probability that let me to developing my own trading strategy as a final effort to try and make some success of trading. Up until reaching the decision of going out on my own I had been following the trading strategies of people who had been marketing and selling their trading systems and strategies.

Some of these strategies conceptually sounded plausible and very appealing but when taken into a live environment they would either be unworkable over the long term or the owner of the systems seemed to have made assumptions about market price behaviour which was not always correct. The equity curve always seemed to spiral downwards or remain choppy for significant periods of time. This was because many of these systems didn't incorporate probabilistic models.

Some systems over emphasize the need for high win rates at the expense of their risk reward ratio. For instance there are some systems that focus on their 85% win rate yet the profit from winnings is 3-4 times less than the liability for each trade. This probably explains why many of these gurus use very small stakes to trade with because they know that those cluster of killer losses are just round the corner. You could have 7 great trades only for a cluster of 2-3 losses to completely knock back a good streak of wins. Having to trade small because you operate in fear of the big losses is one of the reasons why many of these trading systems are simply not scalable in the long term.

Another observation I made, mainly in regards to sports trading, is that many of the systems being marketed have very little fundamental or technical backbone. There are some like James Butler at http://www.betfairprotrader.co.uk who understand the application of particular fundamentals such as Monte Carlo analysis, Sortino/Sharpe ratio and other important statistical factors but he is part of a very small minority.

So this led me to a crossroads where I realized that maybe what I needed to do was stop trying to depend on other peoples strategies and simply build my own. However where would I start? How do I build a profitable strategy from nothing? What should I be looking out for? What core principle should the strategy be built around?

It all seemed confusing until I by chance managed to come across an interview given by Mark Douglas about the Psychology of Trading and this is where my journey really began. I had been looking up about trading and psychology as there were some real collateral damage that had been done to my psyche over the years due to the garbage being peddled on the internet coupled with my inability to handle the emotional side of trading and getting traumatized when trades went against me.

I needed help but without a trading community I felt like the one lone ranger fighting against the market gods. Furthermore, many of the trading communities I did see were swarming with disgruntled people who weren't making any money and with a very negative outlook about trading in general yet somehow wanting to offer advice and guidance.

So an internet search led me to the below video which opened up my eyes to not just the psychology of trading but also understanding the necessity of a probability based approach to trading.

The interview is with the late Mark Douglas, author of the Disciplined Trader and Trading in the Zone.

 
 



 


The key to success in trading is the ability to accept losing a battle whilst knowing you are winning the war

2015-2018 Scientia Trading | Privacy Policy | DisclaimerEmail Us | Twitter | Youtube