Home > Probabilities in Trading – Focus On The Relevant Factors

# Probabilities in Trading – Focus On The Relevant Factors

To trade well, we can’t get bogged down in things that don’t matter. Instead, we must focus on the relevant factors. Some statistical quizzes can help clarify this for us. Then, an understanding of how markets move can provide us with the relevant factors to focus on.

In Probabilities in Trading – How Your Mind Is Tricking You, I introduced some errors people make in regards to probabilities–namely, availability bias and assuming increased probabilities if we can come up with more reasons to back our claim. Both of these tendencies will often lead us astray.

In this article, I discuss these concepts a bit more, but also get into the relevant factors of how markets move…in other words, what to base trading decisions on.

At the end of Probabilities in Trading – How Your Mind Is Tricking You, the following question was posed.

• A man likes two women and is going to ask both of them out via a text message. For each woman, there is a 50% chance she will say YES and a 50% chance she will say NO (like flipping a coin). Neither woman knows of the other, and the answer of one woman in no way affects the answer of the other woman. Our man wants to know what the odds are he will get only one date? Since it could lead to complications, he also wants to know what the odds are he will get at least one date?
• Given that either one says YES, what are the odds the other one will as well?

The woman may respond at different times, so he does not know the order in which he will receive the text replies from the women. He is working out the odds before he receives any responses.

There are no tricks here. The probability for each scenario is our only concern.

When looking at probabilities it can be of great help to create what is called a “sample space.” From the sample space, it is easy to see what the odds of a potential outcome are.

To create a sample space we write down all the potential outcomes. In this scenario, there are 4 potential outcomes, based on each woman saying YES or NO. The potential outcomes are as follows, set up as (woman 1 response, woman 2 response):

(YES, YES), (YES, NO), (NO, YES), (NO, NO).

Using the sample space we can answer our questions:

-The odds he will get one date: 50% (only two outcomes out of four have only 1 YES in them)

-The odds he gets AT LEAST one date: 75% (we include all outcomes with 1 or more yeses – three outcomes out of four).

-The odds of the other saying YES if one woman said YES is 1/3. We know one woman says YES so include all those sample spaces (Yes,No), (Yes,Yes) and (No,Yes). Only one of these satisfies both woman saying Yes, so 1/3.  This last one really messes with most people heads, mainly because the answer involves a three when there are only two women. Most people would automatically “guess” the answer is 25%, 50%, or 75%. Yet, by creating the sample space, it is clear the answer is 1/3, or 33.3%.

On the surface, this little exercise may not seem related to trading. It is, though.

Since very few people get these answers correct, it is likely decisions are being made in trading that are not based on accurate information. How our minds function in trading can greatly affect performance, and not understanding probabilities in trading can mean what you think you are doing is very different from what is actually occurring.

### Sometimes we make things too complex…

Find the highest probabilities in trading means simplifying when we need to, asking the most basic questions and working from there. Such as: is the market moving higher or lower, overall? If that is the case, based on the price oscillating up and down (but moving higher overall), where is the best place to buy and sell? And then asking which is likely to be trigger first, my stop loss or profit target? These questions can get as complicated as you want to make them, but keep them as basic as possible at first, and then (if needed) introduce more advanced techniques to hone in.

Can you keep it simple (keep in mind our brains are not wired for probabilities, so don’t be discouraged if you struggle with these)? Consider the following question:

In university me and friend got drunk one night in a nearby city and failed to make it back for our statistics exam the following morning. We hatched a plan not to tell the professor we were out drinking, but rather to tell him I got a flat tire on the way to the exam (my friend in the car with me). Me and my friend went to the professor’s office and said we were sorry for missing the exam, but we got a flat tire on the way to exam and that missing the exam was unavoidable. We asked if we could write another exam at his convenience. To our surprise he said “OK…wait outside for 5 minutes.”

We sat outside and a few minutes later he came out and handed us both a sheet of paper and sent us to separate rooms. There were only two questions.

On the first side of the page was a statistics question worth 5 points (similar to the one above).

On the other side of the sheet was a second question worth 95 points: “What tire was it?” In order to get the 95 points we both had to identify the same tire.

What are the odds that, not having discussed which tire went flat, me and my friend both pick the same tire? My friend insists there is a 1 in 16 chance; is he correct?

Take a moment and ponder what the odds are we both pick the same tire.

My friend failed statistics. The odds are 1 in 4. After creating the sample space you will see that many cancel each other out, because in this case order does not matter. We either pick the same tire or we don’t.

Traders often make trades much more complicated than they have to be. They see so many variables, like my friend seeing 16 potential outcomes, instead of reducing the trade down to relevant factors. They hear things on TV, read something in the newspaper, or read an article online and believe it will impact the market or will affect the odds of a trade they are considering. They fail to realize almost all these factors are irrelevant and complicate the trading process, and do not increase the odds of success.

As discussed in the first article, the market is going to move in a certain direction regardless of how many arguments I present for or against that move–piling on arguments and indicators to prove a point does not improve odds. This means we must focus on analyzing only factors that affect price.

So what are the relevant factors that affect price, and how do we calculate probabilities in trading?

### Probabilities in Trading: Relevant Factors

To me, there are only two primary relevant factors that drive my trading decisions. Then there are a few secondary factors which can aid in the analysis.

The primary relevant factors are Trend and Magnitude (see Impulse and Corrective Waves and Velocity and Magnitude).

The Trend (or lack of it) affects price, and is the course or movement of price. The trend is relevant because humans are emotional and trends create greed and fear to various extents depending on where in the trend we are. Trends may also include Chart Patterns, which are created and break based on human emotion.

Magnitude determines the volatility, velocity and projected price targets of a move. Price move in waves, sometimes smooth and sometimes choppy. But since we know markets always move in waves, and those waves provide us with information on how the market is moving, magnitude is also very relevant.

Secondary factors include analysis tools used to determine trend and magnitude. For some this may include, trendlines, cycles, moving averages, Fibonacci retracements/fans, an ATR indicator, RSI, etc. No matter the tools used, focus should be given to trend/chart patterns and magnitude. These secondary tools just help us see what we may have missed looking only at the price chart. Typically I don’t like “out of the box” indicators or tools. You are far better off analyzing the charts and coming up with your own settings for indicators (that help you see the trend and magnitude) or simply researching your charts and finding the common tendencies in trends and magnitude. Only use secondary factors to help you clarify what you already see based on trend and magnitude (price action).

### Odds of Winning

So why should you only focus on trend (and chart patterns) and magnitude? Because they tell you everything you need to know, especially when short-term trading. If the price is rising, that is all you need to know. The news doesn’t matter, and who cares what this or that analyst says. If the price is rising, it is rising. Use your strategies to take advantage of that. There is no reason to figure why it is rising, or why it may fall. Trade the rise, and if it starts to fall, get out and trade the falling price. Use the analysis of trend and magnitude to help isolate these trades (and a few tools if needed). I actually avoid news trades, until after the news has come out. Often we can’t predict what a news event will be, or how it will impact the market…but we can trade the trends that come afterwards. I discuss why I exit trades before news events, like stock earnings, in my Stock Market Swing Trading Video Course.

Also, if something totally random happens, like the stock plummets on bankruptcy concerns or skyrockets on buyout rumors….could that be predicted? Often the price moves prior to such moves…the stock is already trending lower before the company’s financial hardships are fully disclosed, or the stock is rallying before the buyout is announced. If this is the case, just focusing on trend and magnitude would have saved or made you money. If there was no prior indication that the price was going to tank or skyrocket, then the event is random, and you couldn’t have known about it anyway (unless you acted on insider information, which is illegal). Random things happen too…that is why I only risk a small percentage of my account on any single trade.

In terms of long-term investing, I use the same tools. I don’t look at fundamentals too much…although I do a bit. Companies that grow earnings and sales quarter over quarter and year over year tend to be in uptrends. This can be considered when looking for trading or investing opportunities. The trend and magnitude are still important, though, because even great companies can get overpriced, and the charts can tell us when it may be time to exit.

With most of my trades, I tend to wait for a trend, and then make trades during the pullbacks in that trend. For example, in an uptrend, I wait for the price to decline. When it stabilizes and starts to turn back up, that is when I buy.

I use magnitude to determine how far prices typically fall before moving back up. I then use trend analysis, and magnitude (looking at historically how far prices rise, and for how long) to determine how long I stay in the trade during the uptrend, or if I need to get out because it moves into a downtrend. Another way of looking at it is that even though I am buying after the price has declined (pullback), I am buying because the larger trend is up (and magnitude indicates the pullback within that longer-term uptrend is likely over).

If a trader’s reasoning for market moves only works in hindsight, but can’t help them make better trades in the future, their reasoning is fruitless and will likely cause more problems than it solves. Focus only on the relevant factors, and give leeway for random events which will occasionally occur without warning.

### Do I Need to Calculate Actual Probabilities in Trading?

If you can find a system that allows you trade with the trend, and then you account for magnitude in determining where to place stop losses and profit targets, you will have already placed the odds in your favor. Losses will still occur, as that is part of trading, but over the long run you essentially become “the house” in Vegas–gaining an edge over other market participants.

So before you place a trade ask yourself two simple questions: Am I trading with the trend? And does the magnitude (movement) of the market dictate that I am likely to be able to get out at my profit target (before my stop loss is hit) within the time frame I want?