Probabilities in Trading – How Your Mind Is Tricking You
Probabilities explain the chance of something happening. Probabilities in trading are often discussed, but humans have an abysmal capacity to understand and calculate probabilities. 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/wrong presumptions.
Are there more six-letter words in the English language where the 5th letter is an n, or more six-letter words in the English language that end in ing?
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.
So are there more six-letter words that have a fifth letter n, or that end in ing? Most say there are more words that end in ing, simple because they can instantly think of some words ending in ing, and thinking of a word with a fifth letter n seems more difficult (so it is not attempted). The answer is: there are more words that have n as their fifth letter.
You don’t need to be an English teacher to know that. It is actually an easy probability inference based on the options presented. All six-letter words ending in ing will also have n as the fifth letter. Therefore, without any knowledge at all, we can know that since ‘n as the fifth’ encompasses all of the ‘ending in ing’, they have at least the same amount of words. Any additional word(s) that have a fifth letter n will make it our winner. The second option is much more specific than the first, and therefore the second option has a lower probability than the first (option two has fewer words).
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 math behind a strategy and finding the slight differences between winning and losing trades–isn’t fun. It is hard mental work, and 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.
Probabilities in Trading
The Availability Bias in trading also affects us in another way, which can be attributed to the media and their incessant pursuit of trying to explain and give reasons for past price action.
Which of the following is more probable?
- That stock XYZ will go up in 2018.
- That stock XYZ will go up in 2018 because it is bought by a larger company, causing the stock to jump 23%.
By explaining everything and trying to give reasons humans fall into a precarious probability trap. When details are given–almost any explanation whatsoever–we tend to believe the scenario is more likely*. Is it? Once again we basically have the “n and ing” question, but now more directly related to trading (did you fall for it again?). The first option encompasses the second option, and all other possibilities which will make the stock rise. The first option has a much higher probability of occurring than the very specific second option. Yet, people are more likely to act on the second option, even though the odds of the stock increasing have not been improved by the possibility of the second option occurring.
Yet, we like to believe in and focus on details. Instead of realizing that a stock simply going up is much more probable than a specific way it goes up, we generally attribute each reason the stock could go up as an addition to the probability the stock will go up. Not so. The stock simply going up encompasses all possible scenarios that could make the stock go up; giving reasons in an attempt to improve the probability of a stock going higher (because of this, and this and this and this and this) does nothing, and is an inaccurate use of probabilities.
Now, as traders, we do give reasons for our trades and our analysis–I know I do. But we must understand that the more reasons we give, does not increase the odds of something moving in our direction. So how does that jive with the fact we each develop certain indicators and methods (hopefully) which do seem to increase our odds of being on the right side of the market?
At different points in both time and price the market will have many factors acting on it. At times these factors will largely favor bulls and at other times largely favor the bears, at other times there may be a stalemate. It is the factors present in the market, not in our heads, that matter. If a trader or analyst sees the major overriding factors that impact the market, he/she will be good (never perfect though) at determining the direction of the market. On the other hand, someone who just tries to find reasons for what they want (the market dropped today so I need to come up with a reason why), will never increase their odds of success no matter how many reasons they come up with it.
This may seem simple, but when it comes to probabilities in trading, this error is committed all the time. A trade goes against us and we start to consider reasons why it should start to move back in our favor. When we do this we play a very different game than we think we are playing. We have inadvertently skipped to option 2 in the above scenarios. We are no longer looking at the factors shaping the market (ultimately determined by price and time) and instead have switched to specific reasons for our belief…reasons which have a smaller chance of being right (yet the random nature of the markets will occasionally still reward us: see my article on Random Reinforcement).
For further reading on why creating reasons for price moves is useless, see The Stock Market is Not Physics, a four-part article series.
Consider the Probabilities of the Following Scenario…
Here is a question to ponder. Look at only the probabilities and not value judgments, etc.
- 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.
The answer is discussed in part 2: Probabilities in Trading – Focus On The Relevant Factors. In this article, I also look more at what factors actually shape the market, and not just what we want to believe. In other words, we learn to look beyond the information that is most available (and often wrong) and see what market factors we should be looking at to improve our trading.
By: Cory Mitchell, CMT
*Giving a reason is also linked to people being more obliging. In an experiment conducted by Harvard social psychologist Ellen Langer, Langer asked people waiting in line to use a copier, “Excuse me, I have five pages. May I use the Xerox machine?” About 60% said YES.
To a different test group, she said: “Excuse me, I have five pages. May I use the Xerox machine because I have to make some copies?” About 93% said YES.
Any reason seems to be a good reason for most people. This should not be the case in trading….or anywhere for that matter.