The Relationship Between Probability And Trading

Guest contribution provided by Forex Traders

There is no such thing in financial markets as a “sure thing.”  In his best-selling book Fooled By Randomness, Nassim Taleb discuss the fascinating phenomena of the Black Swan.  A Black Swan is the thing you just never saw coming.  Taleb is something of an expert on this subject.  He is a 20 year Wall Street veteran, holds a Phd., and is a professor at an Ivy League institution.  In his many years on Wall Street, Taleb has seen countless hot shot traders rise and fall because they believed they had a “sure best.”  Most of the time they fall, it’s due to a Black Swan.

The reality is that, as traders, we deal with probabilities, not certainties.  Very few traders understand the real power of seeing that act of trading through the lens of probability, however.  In this article, we are going to discuss a few basic elements of probability theory and how understanding it can increase a trader’s ability to trade the market in an emotionally-detached state.

Losing Increases Your Probability of Winning

One of the greatest psychological challenges of trading is to see losing trades for what they are—part of the business.  However, there is a more advanced way to see losing trades, and that is to see them as a statistical certainty.  The fact is that trading is not a game of certainty.  Rather it is a game of probability, and it must be perceived and experienced as such. 

Every single time a trader enters the market with a buy or sell order with online forex brokers there is never a 100% guarantee that trade will be closed out in profit.  However, if a substantial amount of strategy development has been done, then a trader should know that over time, his system will perform.  If this is true, then losing trades simply become a statistical certainty.

For example, if a trader designs a system that has a 60% winning percentage, then that means when a position is entered, there is a 40% chance of the trade turning into a loser.  Now, let’s assume the first trade is a loser.  What happens to the probability in the next trade?  Well, the probability that the second trade is a loser will now decrease from 40%.  In other words, statistically, the probability that the second trade will now be a winner is higher than 60%!  The winning percentage of the system statistically increases with each ensuing losing trade.  Of course, this is only if a trader is taking proper trades according to the system that has been developed.

Let’s look at a table that shows this data.

                                Chances of Consecutive Loss After X # of Losses

In the table above, you can see what the chances are of having successive losses if you know the overall winning percentage of your trading system.  Thus, if your system has a 60% winning percentage, the chance that you have a losing trade is 40%.  However, the chance that your next trade is a loser is only 16%.  A person could also create a forex trading software program to calculate these numbers for one’s own strategy.

Seeing losing trades through the eyes of probability in this manner can truly be revolutionizing for a person’s approach to trading financial markets.

By Jason Hoerr�
Market Analyst for Forex Traders

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