Slow Trader

Tag: reward

  • Most important, but often ignored

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

    We realise (because it’s been mentioned a few times) that the difference between a trader and a gambler – if we where to picked 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 (particularly) golf come to mind. I mentioned basketball last week because the point scoring matches well the traders multiples of reward to risk.

    In basketball we can score 3 points from a shot taken from outside of the defenders area; 2 points from inside the area; and 1 point from a free shot, 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. (I like this to be planned risk but it is actual risk that the traders equation depends).

    We could suggest that a basketball shot taken from outside the defenders 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 court to a teammate in the hope of a quick score. The risk of interception is high but the probability, if our own team member catches it, of scoring quickly 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 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 3 point shot at 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 generally very good – instinctively making a workable probabilistic assessment; but as a trader we often ignore this all important aspect.

    Technical trading is a financial ‘sport’ where we can only participate against the professional league. At that level we cannot get 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.

  • Probability

    Most are aware that I took losses at the end of Trump week. No blame to the US president-elect, the responsibility is all mine. Ironically, it came after my boastful ‘fulfilment’ blog. Hey-ho.

    Losses always take ten times longer to make back. But they’re lessons we’ve paid for so we should heed them. To that end, the basics of what we do have not changed; however, entries and targets most certainly have changed.

    We’re all familiar with the concept of risk and reward. However, we rarely consider the third equal partner – probability. In general, the smaller the risk the smaller the probability.

    Therefore, we’ve increased managed risk but also increased probability by taking trades that meet our “always in” criteria. This is not simply trend but a trade taken with context in the direction of a trend bar that has broken a premise point.

    Here’s an example from yesterday of what I mean:

    snip20161203_1

    Left of frame is a down trend with a classic 3 push down. Three measured pushes usually means a reversal. Previously we’d be looking to take the bottom of bar number 1 long, as it’s the third leg down. However, bar number 2 was a ‘final flag’ or a final extension down. Our stop may have previously been set close below bar number 1. Thereby providing a low risk but also a low probability trade. In this example we’d have been stopped out at bar number 2.

    We now, as we did yesterday, enter the trade long at the top of bar number 3. This is arguably a higher risk but higher probability entry. We can see that this bar has also closed above a line of premise. Meaning above the previous high bars to the left.

    The red dashes are my measured targets. My target was close to the top of bar number 5. However, in this instance I came out earlier as bar number 5 was a news based US monthly non-farm payroll announcement – and they can be quite another thing.

  • The most important thing is…

    60% probability of success is the best we can expect from a trade. Even if we think it’s a cert.

    If we look at a trade and say, ‘yeah, I think that will definitely work,’ then the probability is still, at best, 60% that it will happen as we want it to happen.

    On the other hand, if we look at a trade and say, ‘yeah, I think there is a chance of that working,’ then it’s a 40% probability.

    In other words, the best we can expect is between 60% to 40% of being right in any one trade.

    Therefore, our reward needs to be at least twice our risk in a 40% probability trade and at least equal to our risk for a 60% probability trade. Each of these make a positive traders equation.

    Striving for trades that give a positive traders equation is the way to make money over a series of trades.

    Achieving a positive traders equation is the most important thing to grasp, and do, as a trader. 

  • Investing or Trading?

    Investing first:

    Investing is buying into something that appreciates. In stocks and shares, any price increase after about a year is 100% because of the fundamentals: the strength of the books, the management, the continued saleability of the underlying product….to mention a few.

    Most of us have investments in pensions or managed funds.

    Over a bunch of years the market goes up about 9% on average. However, somewhere between 7 to 15 years the market crashes. Timing is everything.

    Moreover, most pension and managed funds don’t beat the market, actually an astonishing 95% of them; on top of that, they charge several percent annually to do so.

    If we need our invested funds, 15 years before would be best, move it into something that is not market based, at least not ‘fundamentally’ based.

    Now for trading:

    Trading is generally over a shorter time frame and is mostly technical based: that is, the reaction of price when price reaches a support or resistance. In its simplest form, it is one person’s opinion (or computers) against another.

    And, as a computer does not have an opinion – it is of course emotionless – that presents the biggest obvious challenge to most human traders.

    Some 75% of trades are institutional based (the big money). The remainder is made up from other entities such as high frequency trading (HFT) systems, large hedge funds and the like. Smaller (professional) organisations and home traders represent less than 5% of the market.

    To be clear, when the (small) professional trader or home trader trades she is up against the institutions – computers mainly – so she better know her unemotional stuff.

    That is probably why few home based traders, particularly lower timeframe traders like day traders, make it. Cheery, eh.

    The one factor more than any responsible for successful trading is – no it’s not luck – is trade management, boring as that sounds. Good trade management always provides a positive traders equation of: risk, reward and probability.

    Without a clear calculation of each of these (and probability is often the one that is missed) then we are not trading but doing something else…gambling, maybe.