OK! Time for a math lesson. Don’t worry if math was never your favorite subject in school. It wasn’t mine either. I promise, no talk about calculus, Brownian motion or standard deviation. Alright, the last one will be a little tough, but I’ll try!
Instead, today’s lesson will be short on the theoretical and long on the practical. So let’s begin.
What’s the probability of a coin toss coming up heads?
Fifty percent! See, that wasn’t too hard.
What’s the likelihood of a coin toss coming up heads twice in a row?
It’s 50% x 50% = 25%
What’s the chance of the next coin toss coming up heads?
If you said 50% x 50% x 50% = 12.5% you’re wrong.
The chance is 50%, because coins have no memory. When you flip a coin, the chance is always 50/50 that it will come up heads. It doesn’t matter how many times it came up heads before.
Some people have trouble getting this wrapped around their heads. Theory says there is only a 12.5% chance of seeing three heads in a row on the coin toss. In reality, if you’re sitting there with two heads already, chances are fifty-fifty that the next toss will also be a head.
So what does this have to do with the price of
snow in Canada?
Well, most people have a misconception about the use of probabilities in trading. The two we’ll specifically look at are:
- Probabilities can save your trade.
- Probability distributions are even.
The first point is something I see a lot in option trading. Beginners in particular feel comforted when they see that their trade has a high chance of being profitable (known as probability of profit). This calculation is related in part to standard deviation. I promised I wouldn’t go there, so I won’t. Most brokerage trading platforms (that specialize in option trading) can perform this calculation on your trade very easily.
So here’s the problem. There’s no such thing as a free lunch. In order to put on a position with a high probability of profit, you need to risk much, much more than you can possibly make. For some this is of no concern. They believe that the likelihood of the trading going sour is very remote.
True, but remotely possible and impossible are two distinctly different concepts. When that 85% probability of profit trade goes bad, that one loss will wipe out the gains of many profitable trades.
Probabilities won’t save your trade. There’s a very real chance that you will suffer a loss. The chance is real. It exists, no matter how remote the possibility may be. Unfortunately, the more remote it is, the greater the loss. So there really is nothing to be confident in, when you put on a high probability trade.
The second misconception many traders have is that occurrences are even distributed. Let’s take the example of a trade that has a 75% probability of profit. Putting this trade on every month, we could infer that the trade will be a winner 8 months out of 12, or 3 months out of 4.
Sounds great, except for one thing. It’s possible you could lose two months in a row. Who knows, you may lose even three months in a row. And there is the possibility, though unlikely it may be, that you lose four months in a row.
Why is this? Well, probability distributions need to be looked at in terms of larger quantities. In our previous example, 4 losses in a row isn’t necessarily unusual. However, 40 losses in a row could be considered out of the ordinary.
That leads us to the following conclusion. Despite what the probabilities of a trade may tell you; “You need to have a maximum loss that you are willing to accept on any trade or investment, in case something goes wrong.”
