Sapphire | Blogs

Admin123 : Sid Bhattacharjee
Date : 2020-11-11

Probability, the very best friend of a trader!

Statistics play a major role in the life of a trader; in fact, in our view Probability is one of the best friends of a trader. For any single trade, chance is a big factor. If a strategy has a 55% probability of working in your favour, you have an almost even chance of making or losing money on an individual trade. However, you have nearly a 100% chance of being profitable on 1000 trades if you have a higher than 1:1 reward-risk ratio (RRR). RRR will be subject of discussion in another blog, but for now, just note that RRR is defined as a quotient of Reward to Risk or the Profit in $ for every $ risked or in any other currency. With a good strategy, the odds are weighted in your favour.

Probabilities explain the chance of something happening. A full mathematical treatment on the subject of Probability is perhaps too much to include in a blog post but let’s discuss why and how Probability is so important in the life of a trader based on the some basic and easily understandable concepts. However, let’s make one simple assumption in the discussion is that probability of certain outcome in one trade is independent of the probability of outcome of the second trade, if the trades are placed on two different underlying Stocks or ETFs. The reason for this assumption is that, in most cases the trades are placed on separate Stocks and ETFs and not all trades are placed on the same underlying. However, if the trades are placed on similar type of underlying such as SPY and SPX, then the assumption will not hold good as these two underlying move in similar direction. For simplicity, we will keep such trades outside of purview of this discussion.

Thinking Probability is a mindset, but unfortunately humans have an abysmal capacity to understand and calculate probabilities as our minds are just not hard-wired for it. We love to assign probabilities though, but the probability assigned to an event is often grossly inaccurate, or based on inaccurate and wrong presumptions or some kind of preconceived notions or bias.

Our issues with probability are compounded by many factors, but one overwhelming factor is Availability Bias. Availability Bias is when we draw conclusions based on the information most readily available to us, which is often inaccurate. Based on this we often draw quick conclusions instead of thinking something through. As in life, Availability Bias in trading is prevalent.

We are bad at probabilities and at looking closely at what is right in front of us. This is also a problem with trading. The really hard work–the going through charts and writing down winning and losing trades, calculating the mathematics and statistics behind a strategy and finding the differences between winning and losing trades isn’t fun. It is hard mental work; so most people skip it. But this is exactly the work that is the difference between a trader that makes it and one that doesn’t.

Do I Need to Calculate Actual Probabilities in Trading?

Probability may simply be ascertained from the number of successful outcomes to the total number of possible outcomes. As an example, if you have a trading system using which you had placed 10 trades over a period of time of which you had 8 successful outcomes; then the trading system has an 80% probability of success. Many traders actually keep track of their trades over long period of time to ascertain the probability of success of their trading system.

Alternatively, analytical tools or trading applications may be used to help assess the Probability. These trading applications or analytical tools use a proven trading system, goes back in the history looking for setups as per the trading system and then computes how many trades were successful from among the total number of setups according to the trading system. These trading applications not only provide the Probability as mentioned above, they provide a great level of insight on a range of parameters of interest to the trader. Those insights include, the high and low levels reached by the Stock or ETF within certain number of days (usually in weeks), time taken to reach these levels for each occurrence of the setup and often with charts to show all the history. When you start using such level of information, you already put the odds or Probability in your favour, readily handed over to you. You may track the trades in separately to see how the Probability had indeed played out as Probability is not certainty. If the probability does not play out as intended or expected, risk management would kick in to protect the capital and this is where RRR plays the important role.

Just as a side note, there is one in three chance or 33.3% probability of a Stock or ETF going up in any timeframe, because the stock could go in only one of the three possible directions; go high, go low or go sideways. But with 33.3% Probability, the RRR needs to be just over 2:1 or the trade needs to make $2 for every $1 risked, only for break-even. But if you have trading opportunities where the Probability is 80% or even 90%, the profitability would sky-rocket. That’s what a trader should be aiming for in their trading plan.

So, a better way to trade is to find opportunities that has high Probability, preferably in the vicinity of 80%-90%, and then place the trade in such a manner that provides about 2:1 RRR. By doing so, the odds are stacked very highly in your favour.

Please visit the following URL for more information on various trading applications from Sapphire Capitals which are designed to deliver high probability trading opportunities for swing trading as well as for intraday trading:

Wishing you all the success in all your trading endeavours.

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