Achieve Better
Trading Results By Mastering Probability
By
Don Miller
TradingMarkets.com    Â
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:Â
-
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;Â
Â
-
A re-entry based on a
similar premise of the market holding key support, followed by a
$0.10 stop when support fails; andÂ
Â
-
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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