Thinking in Probabilities
Apr 26, 2024Throughout our lives, we are thought that if we practice something hard enough, study some knowledge intense enough or put in the work long enough, we will eventually be master the art or craft, the endeavour we were putting all the effort towards to. There is nothing wrong with this thinking. In fact, it is the drive, which is deep within the human body, which let us advance over generations. This is the way to develop from a novice to grandmaster.
BUT - and this is an important but – the art of trading doesn’t work that way. The biggest misconception about trading is that you “can put in the hours” and get a linear reward from it, just like with 99% of other undertakings. This is just further from the truth as it can be.
How most traders carrier is going to be:
- Initial Attraction: They learn about trading from social media, attracted by the the money, the freedom, the prestige, and the independence.
- Overwhelming Information: They start researching trading and get overwhelmed by the vast amount of information available.
- First Steps: Enthusiastically, they open a brokerage account, learn some strategy and follow popular advice. At this point the quality of knowledge learnt, actually doesn’t matter.
- Dismissal of Psychology: They encounter the concept of trading psychology but dismiss it rather quickly because it doesn't promise to make them a millionaire overnight...
- Experiencing Drawdowns: Whether they profit initially or face losses, they eventually experience a significant drawdown.
- Deepening Skills: In response, they believe they need to deepen their chart analysis skills, adjust their strategy, or increase their trading size to recover losses.
- Vicious Cycle of Loss: They enter a cycle typical of losing traders: alternating wins and losses, increasing risk, continually adjusting strategies, which often leads to a severe drawdown.
- Realization and Retreat: At this point, 90% of traders recognize that the idea of trading full-time for significant profit and freedom is unrealistic, and they abandon trading.
- Refusal to Quit: However, some feel challenged and refuse to admit defeat.
- The Final Split: The enduring few split into two groups: those stuck in a cycle of trial and error with various strategies and indicators, often losing everything, and those who take trading psychology seriously, adjust their behavior and mindset, and start earning consistent profits.
These successful traders master the art and realize that achieving the money, the freedom, the independence, was simpler than expected. Exactly what they were hoping for in the first place.
What’s the solution?
It's quite straightforward, though perhaps disappointingly mundane:
Their thinking is misaligned when it comes to trading.
The shift from “thinking according to common sense” to “thinking in probabilities” is where most struggle. Every trading strategy, no matter how professional or sophisticated, will have periods of losses. So, there is no need to dive even deeper in chart analysis. Every strategy provides merely an "edge" - a means to tip the probabilities in your favor.
Understanding an Edge
Consider a casino. Everyone can agree that when gambling in a casino, you will eventually lose. Everyone also agrees that winning or losing is random—it's simply "luck", right? Moreover, it is universally acknowledged that casinos remain profitable; otherwise, there wouldn't be so many of them.
So how is it possible that, despite the randomness of wins and losses, every casino remains profitable over a monthly or yearly time frame? If it were truly random, some casinos should lose money while others profit.
This is because the casino has an edge over the player that slightly tilts the odds of losing in their favor. If the casino wins just 51% of the time, it remains profitable over the long term.
Applying This to Trading
When starting to think in probabilities, you must first define an edge. This includes a consistent trade size, a clear and repeatable entry signal, and explicit signals for taking profits and stopping losses.
You must then follow this strategy relentlessly to let your odds play out. Remember, wins and losses are randomly distributed, but if your chance of winning is higher than losing, you will be profitable in the long term.
Here's a concise practical exercise manual to help you discover your trading edge's probability rate:
- Choose Your Market: Select a market (Stocks, FX, Crypto...).
- Define Your Trading Edge: Establish clear rules for your trading strategy:
- Trade Entry: Specify the exact conditions for entering a trade.
- Stop-Loss: Determine the exact point for exiting the trade to minimize losses.
- Time Frame: Choose one time frame and stick to it throughout this exercise.
- Take-Profit: Define the exact conditions for taking profits.
- Risk Acceptance: Decide how much you are willing to risk per trade (e.g., $10 per trade or a set amount divided by the number of test trades).
- Commit to the Rules: Commit to executing at least 20-30 trades strictly following these rules. Do not deviate from them under any circumstances.
- Start Trading: Implement your strategy according to the defined rules.
- Evaluate Performance: After completing the test trades, tally up your wins and losses. Calculate your edge's probability based on these outcomes.
This exercise will help you gauge the effectiveness of your strategy and understand the probability of success in your chosen market.
If you haven't yet found your edge, check out our Trading Mastery class. We can help you define a clear trading plan and assist in aligning your mindset.
In the end, always keep in mind: Be the casino, not the gambler.