December 22, 2014

Probability and stock markets

Something as simple as high school maths can have a dramatic impact on your trading.

A trader's current views of probability could be completely wrong, and they could very well be why they are not making money in the markets.

For eg., any coin toss has a 50% chance of being right. In other words, a coin toss has a 50% probability of giving either a head or tail. This is similar to taking a long position and not knowing if it will result in profit or loss the next day (or month). But the probability of a profit or loss is still 50%.

Let's assume that at a given moment in time the stock could just as easily move up as it could move down. Thus our probability of making a profit (whether short or long) on a position is 50%. Where people make a mistake is in assuming that after a series of "winning trades" the chances of a losing trade increase. This is a common misconception. Each event still has a 50% probability irrespective or previous outcomes.

Our odds of success are still 50% irrespective of what the previous outcomes were! People lose thousands of rupees in the markets by failing to realize this.

The reason this is so important is that often, when traders get into the market, they mistake a string of profits as sign of skill or intelligence (and vice versa). This is simply not true.

Put differently, a series of profitable trades does NOT make a trader a genius or an intelligent person. The probability of the next trade working out profitable is still 50%.

This also means that a trader should not increase his or her position size or take on more risk (relative to position size) simply because of a string of wins, which should not be assumed to occur as a result of skill. It also means that a trader should not decrease position size after having a long, profitable run.

This information should be good news. For new traders, it means that their researched trading system may not be faulty, but rather is experiencing a random run of bad results (or it may still need some refining). It also should put pressure on those who have been profitable to continually monitor their strategies so they remain profitable.

NOTE: Trends exist in stock markets so this might not make markets a 50/50 gamble. Stock prices tend to run in a certain direction over periods of time and this means that traders can be profitable on a faily consistent basis if they follow trends.

So while we will have "fat tails" in the bell distribution curve, the core concepts of probability and risk management do not change. It still means that a string of profits does not mean you have a skill or you are a genius.

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In above example, chance of getting 3 consecutive heads or tails is 1/8 and is the same as any other combination. But the chance of the next toss giving head or tail is still 0.5 or 50% and is independent of previous outcomes.

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