Most important, but often ignored

Probability is something we understand very apparently when it comes to sports, but it seems to be a concept that we struggle with as a trader.

We realise that the difference between a trader and a gambler – if we were to pick one thing – is adding or not adding probability into the mix of reward and risk.

Some sports lend themselves very well to the example of probability. Basketball, tennis and golf come to mind. I mentioned basketball last week because the point scoring matches well the trader’s multiples of reward to risk.

In basketball we can score 3 points from a shot taken from outside of the defender’s area; 2 points from inside the area; and 1 point from a free throw, if the opponent commits a foul. As a trader we often look to achieve a minimum target that is 3, 2 and 1 times our actual risk. (We use planned risk, but it is actual-risk that the trader’s equation depends).

We could suggest that a basketball shot taken from outside the defender’s area has a probability of success that is low (it’s a long way to throw it!); however, the risk is also low as the defending team have little chance of a quick, undefended, attack in reply.

A 2-pointer attempt is medium in probability as the (6’7″) defenders are there with us in the shooting area. It is also medium in risk as it is a dynamic manoeuvre and often with the full commitment to the shot from most, if not all, of the team; a quick steal and counter-attack is possible.

A free shot is never available in trading. Therefore, I’d equate the 1-point attempt, in basketball terms, to the lob up the court to a teammate in the hope of a quick score. The risk of interception is high but the probability, if our team member catches it, of scoring is also high.

All well and good, but where does this take us in financial traders terms? As a trader, and regardless of which timeframe of the chart we trade, we’re all looking to take trades where the probability, reward and risk make good sense. To do otherwise is, as we’ve said, gambling.

As an aside, as a trader, we’re always participating in the basketball equivalent of the NBA championships because the trading professionals (institutions and the like) make up most of the opposition and in this ‘zero-sum game’ they’re always-in.

In our basketball match, if we lob the ball up court but we don’t have a team member to receive it we have given the ball away. If we take a three-point shot at the basket when we have no defenders between us and the basket we have merely reduced our probability for no good reason.

Our judgement of probability in sports is very good – instinctively making a functional probabilistic assessment, but as a trader, we often ignore this all-important aspect.

Technical trading is a financial ‘sport’ where we can only participate in the professional league. At that level we cannot get the probability, reward and risk confused. To do so is the same as chucking the ball up court without a receiver.  As want-to-be traders, however, we seem to do this all the time (ignore probability) and wonder why we don’t win.

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