Achieve Better Trading Results By Mastering Probability
As I was preparing the content for
my QQQ video during this past summer, I
felt strongly that several foundational concepts had to be laid, prior to
discussing specific methods, indicators and setups. One of the cornerstone
principles was that of trade probability.
Indeed, one of my biggest pet peeves in this business is that of traders
constantly searching for that perfect system, newsletter, or so-called
“guru” that will catapult them from failure or inconsistent
performance to immediate and consistent profitability, when no such thing exists.
As such, one of the industry myths I wanted to address as a prelude to setups
was the following:
So what’s the big deal about probability? Well, I
strongly believe that success in trading is far more dependent upon the
understanding, acceptance and application of probability principles than any
other facet. While the concept of probability may seem simple and reinforcing
for some traders, grasping and making probability
do the work for you remains a strong challenge for many who continue to struggle
in their trading journey.
The Uncertain Future
One indisputable fact in this, or any other business, is that no
one can predict the future. While this point may seem ridiculously obvious, let
me repeat it for emphasis — no one can predict the
future. As mere mortals, we’re all trading on what many have called
the “right side of the chart,” and neither I, nor you, nor
the top traders in the world can tell you what the market will do in the next
minute, hour, day or week. And while it might seem unimaginable to think
anything less, many emerging traders seem to spend day after day searching for
that Holy Grail, crystal ball, analyst, stock caller, or other device that will
rid them of the requirement to operate in an environment of continual
uncertainty.
Perhaps you’ve seen traders who take great pride — perhaps even
boast — of their ability to accurately “predict” a market’s movement.
Or perhaps you’ve gotten personally frustrated over a trade entry because the
market moved in the other direction, leaving you with a feeling that you were
“wrong.” Yet since no one can predict the future, how can there ever
be a right or wrong? Chest-pounding or perceived trade “failures” are
clear cancers in this business, as uncertainty prevents there from ever being a
right or wrong.
One interesting
note: Having worked with dozens of
emerging traders over the last few years, as well as looking back at my own
development and evolution from the corporate life to the trading profession, two
particular backgrounds come to mind when I think of traders who struggle to
operate in the realm of uncertainty: engineers and accountants (including
myself). Why? Because individuals whose strengths may shine in such
specialized fields that require constant precision will often struggle when
attempting to operate in an environment absent of equations, logical formulas,
spreadsheet footings, and the like.
So how do we begin to overcome the challenges inherent in an
uncertain environment? The answer is to see a simple bias that skews probability
in one’s favor over multiple trades.
Seeking A Bias
Many folks have commented on my rather “simple” view
of the market. As I’ve noted in the past, I use just three indicators in seeking
trade entries: One determines trend (moving averages), one defines momentum
strength (stochastics), and another defines a trading range (Bollinger bands).
That’s it. Three. And one of them (MA) is about as basic as one can get.
So
why would I choose a rather simple and mundane approach to the market when there
are multitudes of other indicators available? The answer is that I’m simply
attempting to leverage off historically repeatable pattern biases whose only
function is to skew probability in my favor over time. I view such an approach
as analogous to flipping a rigged coin (one that is unfairly weighted toward
heads) time and time again. We know that the result will be heads much of the
time, tails occasionally — including periodic consecutive attempts — and we
really don’t care if any particular toss comes up heads or tails.
One of the main reasons I encourage newer traders to focus on a
single market, such as the QQQ, is that doing so fosters a suitable environment
where trade probability takes precedence. By executing multiple trades of the
same commodity, equity or market — using a constant pattern, trigger and stop
mechanism — that results in a favorable outcome more times than not, sample
size, time and probability will essentially do the heavy lifting. In fact, while
top traders continually seek a bias, many will operate successfully even without
such a bias.
Why Win/Loss % Can Be Irrelevant
Over the years, some have asked for my views on an appropriate
win/loss percentage on a trade-specific basis. My response is that while such a
percentage may be a valid measuring stick for certain traders and methods, there
are many styles for which the win/loss concept is a totally irrelevant tool — and
potentially dangerous, if it places focus in the wrong area.
For example, an
intraday trader who prefers to have a position in the market to catch a critical
anticipated move can have a ratio far less than 50% and be highly profitable, as
is indeed the case for many world-class traders. Consider the following trade
sequence for an intraday scalper:
-
An initial QQQ pullback entry as the
market approaches trend support, followed by an immediate trade scratch when
changing market conditions render the premise for the entry invalid for a net of
$0.00; -
A re-entry based on a similar premise of the market holding key
support, followed by a $0.10 stop when support fails; and -
A final re-entry
upon the market not following through on the trend reversal, followed by a
profitable $0.50 exit. In this case, the win/loss % was a mere 33%, with net
profits of $0.40.
Now let’s do a quick reality check on that sequence.
Is the sequence unrealistic? Not
at all, as such a trade-management plan reflects a successful blueprint for
effective trading for many, including me. Specifically,
positioning for trend reversals, such as those reversing via “cup-and-handle” breakouts, often requires such a style.
Is such a concept only relevant to
intraday scalping? Absolutely not. Consider the unfortunate events of
Sept. 11, 2001. Many will recall that the Nasdaq was showing numerous signs of
turning, just prior to the tragic events. Significant price vs. stochastic
strength divergence had developed on the hourly chart, and lesser intraday
trends had begun to turn northward. (If you recall, we were actually gapping up
early on the morning of 9/11.) Several other indicators, including TM’s
market bias, were lining up accordingly. Given the resulting market dynamics
upon reopening on 9/17, the subsequent downtrend extension and consolidation
from 9/17-10/2, and the final turn on 10/3, a similar entry/stop (9/10-9/11),
re-entry/stop (9/17), and final entry (10/3 when the daily trend reversal
triggered) with many opportunities for profitable exits, reflects a very likely
scenario which mirrors the precise sequence illustrated above.
Wouldn’t commission costs add up and
offset the ultimate gain(s)? Commission costs are undoubtedly a cost of
doing business and will certainly increase as trade volume increases. Yet, as
commission rates have dropped substantially over the last several years (in
some case, 90% reductions from $100 to under $10), the result has been
increased profitability for this particular style.
While I’m certainly not advocating or encouraging hyperactive
high-volume trading, which clearly isn’t for everyone and will increase
transaction costs, the key concept is that of simply not missing the forest for
the trees. If a trader’s ultimate objective is the generation of net trading
income over the course of a month, quarter or year through the use of effective
trade and risk management, overemphasizing a micro statistic, such as
trade-specific win/loss, can result in misdirected focus for some.
Again, these concepts may seem startlingly obvious for some, yet
why does it seem that the concept of probability is so neglected and discussed
so rarely among trading circles? A few possible answers — that unsurprisingly,
reflect the general undoing of many traders — may provide clues:
Personal Ego — Many traders
attempt to use the market to satisfy an inner urge to prove themselves above
others and are focused on being right, rather than being profitable. While
trade successes may very well appear on occasion, consistent and lasting
success will likely be highly elusive.
Pursuit of the “Thrill”
— With hype ridiculously rampant in corners of this industry, and with many
pursuing trading for the perceived thrill and excitement, such industry
illusions can easily result in a misdirected trader’s focus being 180° from where focus
is necessary. Those misguided are often eventually faced with making one of
two decisions: (1) pursue boring consistent profits following probability
concepts, or (2) engage in the most expensive thrill ride ever constructed.
Lack of Discipline —
Effective use of probability requires a disciplined approach, a trust in
key probabilistic components, such as the chosen pattern, and a recognition of
a need to keep the pattern constant even during times where the result of
lesser probability may be occurring. Back to our coin example, flipping that
coin weighted toward heads, it may very well land on tails three or four
times in a row, at which point many traders would simply move on to a
different pattern or method and unknowingly remove a required constant.
There has been much written on the
subject of probability, of which I’ve admittedly only scratched a few surface areas. Yet I hope the
perspective helps to introduce (or reinforce for some) why and how probability
plays such a critical role in the business of continual uncertain speculation.