Socrates understood the importance of “knowing thy self”. In other words, knowing your strengths, your abilities and how you can best employ them to your own advantage. Socrates also believed the best way for people to live was to focus on self-development rather than the pursuit of wealth.
The same concepts can and should be utilised in your approach to trading. To progress through the Four Stages of Development, a trader must focus on self improvement rather than profits. By focusing on self improvement you expand on your strengths, abilities and thought processes. This in turn generates the profits you desire as a trader.
The process of self development is not limited to the identification of your strengths and abilities alone. It should also lead you to a deeper understanding of your trading strategies.
Why is this important?
Understanding your trading strategy intimately breeds confidence. Having confidence in your trading strategy enables you to ride the ups and downs whilst continuing to trade your system.
Confidence and consistency in your trading will lead to consistent profits. And we all want that!
Developing Confidence in Your Trading Strategy
To building confidence in your trading, start by breaking the process down into four steps:
1. Identify your personal, financial and lifestyle objectives;
2. Have an appreciation of your Risk Tolerance;
3. Design and test thoroughly your own trading strategy (ensuring it’s in line with your objectives and risk tolerance).
But as we know, typically this is not enough.
The fourth step is arguably the most important. It consists of two concepts that are critical to your understanding of your trading strategy:
a) the impact of probability on your trading strategy; and
b) the likelihood and duration of losing streaks associated with that strategy.
Understanding the Probability of Trading
Probability can be defined as how likely it is that an event will occur. In the financial markets an event could be a winning trade, a losing trade or a trade that breaks even.
In order to gain confidence in yourself and your trading strategy, it is vital to understand just how the concept of probability impacts on your profitability.
The probability of trading effects your trading in two ways:
- Firstly, probability affects your trading from a general perspective (i.e. how likely your next trade will be a winning trade rather than a losing one).
- Secondly, probability impacts on your trading through the likelihood of suffering a series of consecutive losing trades and subsequently how you choose to respond to these loses.
Let’s start by looking at an example probability from general trading perspective.
If you designed a trading system with a 70% accuracy rate and of your last nine trades, six were winners and three were loses, then what do you think the odds would be that the next trade is a winner?
The answer is 50%.
That is, your next trade is just as likely to be a losing trade as it is a winner.
Now some of you may be asking why?
If the first nine trades had six winners and three losers and the trading system has a 70% accuracy rate, surely the next trade has a higher probability of being a winner?
Well not necessarily. Let me explain why.
Independent vs. Dependent Events
Traders and to a less extent investors often misunderstand the notion of dependent verses independent events. In probability terms an independent event is where past events have no influence on future outcomes. Dependent events, on the other hand are events where the outcome or occurrence of the first affects the outcome or occurrence of the second event.
Flipping a coin is an example of an independent event.
For example: when flipping a coin there two possible outcomes, you can either toss a head or you can toss a tail.
Therefore the probability of getting a head is ½ or 50%.
When you flip a coin, the probability of tossing a head does not change – no matter how many times you flip the coin.
Even if you flip a coin ten times and the first nine flips are heads, the probability that the last flip will be a head is still ½ or 50%.
The probability is still the same as if the first nine flips had never occurred (i.e. the outcome of the toss is not dependent on any previous toss).
Trading is no different.
When you place a trade each trade is independent of your previous trades. Each new trade has an equal chance of being a winning trade as it has of being a losing trade.
Of course there is a third alternative – the breakeven trade. However before a trade can breakeven, the trade will either be in a winning or losing position. Therefore in an effort to keep it simple, it’s much easier to focus on winning and losing trades only.
So what about ‘High Probability’ trading strategies?
Some trading strategies do tend to be more reliable (i.e. offer a higher accuracy rate) than other strategies, but the reality is that every time you enter a trade, regardless of the accuracy rate of your strategy, the price of the security is just as likely to rise as it is to fall. The outcome of the trade is independent of your trading strategy and your previous trades.
In other words, the price action of a security is beyond you and ‘your systems’ control.
Yes some traders design highly accurate trading strategies, some in the order of 70+ % accuracy, but for the most part the average trader is trading a system with a 50% accuracy rate at best.
In the next post we’ll go beyond the general implications of probability on your trading and explore the impact of probability on your trading strategy and in particular the effects of losing streaks.
‘The No Bull@#t Guide to Achieving Profitability’
If you can’t wait until the next post, I recommend you download my FREE Manual ‘The No Bull@#t Guide to Achieving Profitability’.
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‘Til next time, I wish you the ultimate in trading success.
