Start thinking in Probabilities and change your trading forever!
It's Tuesday and we're back in action again after a longer than usual break away from the markets.
In today's post I'd like to talk to you about how a real trader should think, and as the legendary trading coach, Mark Douglas, puts it... a real trader thinks in terms of probabilities. That is what today's post will be covering!
Not to long ago I read about something that made me think a little more, and that is "Expected Value", in both trading and life, I could talk a lot more about this, and in the near future I will, but for now I don't have the time nor do you have the interest to read a book in a blog post, so I'll just focus on the core lessons.
Expected Value is best explained in the following way:
This is a number which indicates, based on probabilities, the value of executing a certain action multiple times (over and over) and getting a similar result.
Basically the result can be positive or negative, in trading the question is: Will the trade make money? and in life it is: Should I change careers? Should I marry/stay with my partner? It all comes down to Expected Value.
The next point to answer is what makes up Expected Value?
Two factors complete the answer to this question: Bat Rate% and Win / Loss.
Bat rate is the percentage of wins vs total outcomes and Win/Loss is the size of the average winner divided by the size of the average loser. In other words;
What is the chance this works?
How big is a win?
How big is a loss?
When you combine these answers, you can much more clearly understand whether or not it makes sense to take a certain action.
Let's say, for example, that a certain trade idea has a 50% chance of working. A win earns you $20, while a loss loses you $10. Should you take the trade? Let's find out!
In this example, you take this trade 100 times. 50 times, you win $20, and 50 times you lose $10. You'd end up with a total profit of $500! ((50x20)-(50x10)).
Clearly, the above mentioned trading process has a positive expected value! So, even if you take the trade and end up with a loss, you still made the right decision. This is why it is soooo important to think and trade in terms of probabilities and remain focused on YOUR PROCESS/SYSTEM!
The tricky business with Expected Value all of what we just mentioned aren't hard numbers, they are mere estimates. Thus, building a feel for the likelihood of something happening, and building an understanding of the amplitude of wins and losses is a key skill to build for trading and life.
Nothing of this works if you don't work your trading system, this is something I must warn you about. Following your entry process to the absolute dot is imperative, if you deviate from the process you're building a trading career on sand, and it's only a matter of time until you, and your trading account, crumble!
That's all I've got for you in this one! Hope it helps!