Today’s Trading Lesson From Trading

Editor’s
Note:

Each night we feature a different lesson from TM
University.
I hope you enjoy and
profit from these.
E-mail
me
if you have any questions.

Brice

Achieve Better Trading
Results By Mastering Probability

By
Don Miller

TradingMarkets.com

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: 

  1. 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; 

  2. A re-entry based on a
    similar premise of the market holding key support, followed by a $0.10 stop
    when support fails; and 

  3. 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.

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