The Numbers Game (Part 2)

So, we've seen a glimpse of the fact that frequency or probability would be rather useless if not considered in conjunction with the magnitude of the outcome.

Let's dabble more into the concept of reward:risk and expectations.

I'm frequently pressed for my 'call' on any given currency pair. To the ill-equipped (without basic understanding of probabilities), my honest & straightforward answer comes across as confused jibberish... when in fact (and I try to put this across as delicate as possible), it is they who are mired in confused jibberish and are desperately trying to make any sense of the market.

To side-track a little, notice that the words bullish and bearish, both end with the adverb "ish"... meaning; (1) somewhat, (2) reasonably, fairly, (3) about, approximately. Remember, when dealing with price movements, we're not dealing with certainty.

Using our example from the previous post, we recall that GBP/USD is at 1.6480 and below the Daily R1 (and where shorts are favoured to longs by 58% to 42%). As I mentioned above, probability without considering magnitude is useless.

We need two further pieces of information, i.e. the Daily R2 (1.6580) and the Daily PP (1.6300).

(Note: for the examples, spreads are ignored for simplicity)

Event: Probability x Outcome = Expectation
Price goes up: 42% x -100 = -42
Price goes down: 58% x 180 = 104
Total = 62

(Re:Ri = 180:100, i.e. 1.8:1)

Clearly, going short results in a positive expectation.

If price goes above Daily R1, it would be easy to think that expectations are still with us and we should be simply selling into strength, i.e. go short. However, note that if the improbable does happen you'll be facing with a 100 pip loss at the very least... and if a strong breakout occurs, and price goes past Daily R2 to Daily R3 or even beyond that, you will be staring at a significant intraday drawdown which may force a margin call or worst, blowing your trading account.

This is where the use of stop-losses come in. Many amateur traders have difficulties accepting losing trades, mainly due to psychological reasons that I shall not get into today. With all seriousness, incorporating stop-losses into your trading is akin to putting on brakes on a Formula 1 car. Whilst having the fastest car on the track is a major advantage... notice that what separates the best driver from the rest is the ability to overtake when braking and turning into a corner!

Let's see how it works, using the same data as the above example... except this time, we put a 30 pip stop-loss.

Event: Probability x Outcome = Expectation
Price goes up: 42% x -30 = -13
Price goes down: 58% x 180 = 104
Total = 91

(Re:Ri = 180:30, i.e. 6:1)

So, we've actually 'improved' our positive expectation.

And, let's say if the stop-loss is hit, we 'reverse' and now go long (again with a 30 pip stop-loss) with the comfort that the Daily R1 is now below us and serves as a support level.

Event: Probability x Outcome = Expectation
Price goes up: 42% x 80 = 34
Price goes down: 58% x -30 = -17
Total = 16

(Re:Ri = 80:30, i.e. 2.7:1)

(Note: potential reward to Daily R2 is 80 accounting for the fact that the new buy order is at the same level as our stop-loss level)

Amazingly, it seems, expectations for going long above the Daily R1 is now also positive, as opposed to being negative if without one (see below).

Event: Probability x Outcome = Expectation
Price goes up: 42% x 80 = 34
Price goes down: 58% x -210 = -122
Total = -88

(Re:Ri = 80:210, i.e. 0.4:1)

Now, you've caught a glimpse of how truly successful traders go about the very serious business of trading the financial markets. I therefore strongly urge you to stop being ill-equipped for the sake of your own long-term trading survival and profitability.

So, you see, accuracy in forecasting price movements is truly overrated. The traders you should actually be paying attention to are the ones, when asked for calls, forecasts and predictions, simply answer back "I don't make predictions, period." Leave that to the economists, strategists, analysts and salespeople.

Remember, trading is a numbers game. :-)


WeeTrader said...
This comment has been removed by the author.
WeeTrader said...

Sorry... Speeling errors in last post...

Hi MiniBahnThatCan!

You are a genuinely nice guy, otherwise you would definitely be charging for this! Fascinatingly simple! Am looking forward to trying-out the long-term method

Post a Comment

Fixed Ratio Money Management

It's been a while since I last blogged about Money Management, what many consider to be the most important yet overlooked subject in trading. As one of the three (3) pillars of trading success (the other two being Mind and Method), I therefore feel that I have an obligation to share more of my thoughts on the matter.

Click HERE for more

Visit my other blog