Achieve Better Trading Results by Mastering Probability

As I was preparing the content for my QQQ video during this past summer, I felt strongly that several foundational concepts had to be laid, prior to discussing specific methods, indicators and setups. One of the cornerstone principles was that of trade probability. Indeed, one of my biggest pet peeves in this business is that of traders constantly searching for that perfect system, newsletter, or so-called "guru" that will catapult them from failure or inconsistent performance to immediate and consistent profitability, when no such thing exists. As such, one of the industry myths I wanted to address as a prelude to setups was the following:

So what's the big deal about probability? Well, I strongly believe that success in trading is far more dependent upon the understanding, acceptance and application of probability principles than any other facet. While the concept of probability may seem simple and reinforcing for some traders, grasping and making probability do the work for you remains a strong challenge for many who continue to struggle in their trading journey.

The Uncertain Future

One indisputable fact in this, or any other business, is that no one can predict the future. While this point may seem ridiculously obvious, let me repeat it for emphasis -- no one can predict the future. As mere mortals, we're all trading on what many have called the "right side of the chart," and neither I, nor you, nor the top traders in the world can tell you what the market will do in the next minute, hour, day or week. And while it might seem unimaginable to think anything less, many emerging traders seem to spend day after day searching for that Holy Grail, crystal ball, analyst, stock caller, or other device that will rid them of the requirement to operate in an environment of continual uncertainty.

Perhaps you've seen traders who take great pride -- perhaps even boast -- of their ability to accurately "predict" a market's movement. Or perhaps you've gotten personally frustrated over a trade entry because the market moved in the other direction, leaving you with a feeling that you were "wrong." Yet since no one can predict the future, how can there ever be a right or wrong? Chest-pounding or perceived trade "failures" are clear cancers in this business, as uncertainty prevents there from ever being a right or wrong.

One interesting note: Having worked with dozens of emerging traders over the last few years, as well as looking back at my own development and evolution from the corporate life to the trading profession, two particular backgrounds come to mind when I think of traders who struggle to operate in the realm of uncertainty: engineers and accountants (including myself). Why? Because individuals whose strengths may shine in such specialized fields that require constant precision will often struggle when attempting to operate in an environment absent of equations, logical formulas, spreadsheet footings, and the like.

So how do we begin to overcome the challenges inherent in an uncertain environment? The answer is to see a simple bias that skews probability in one's favor over multiple trades.

Seeking A Bias

Many folks have commented on my rather "simple" view of the market. As I've noted in the past, I use just three indicators in seeking trade entries: One determines trend (moving averages), one defines momentum strength (stochastics), and another defines a trading range (Bollinger bands). That's it. Three. And one of them (MA) is about as basic as one can get.

So why would I choose a rather simple and mundane approach to the market when there are multitudes of other indicators available? The answer is that I'm simply attempting to leverage off historically repeatable pattern biases whose only function is to skew probability in my favor over time. I view such an approach as analogous to flipping a rigged coin (one that is unfairly weighted toward heads) time and time again. We know that the result will be heads much of the time, tails occasionally -- including periodic consecutive attempts -- and we really don't care if any particular toss comes up heads or tails.

One of the main reasons I encourage newer traders to focus on a single market, such as the QQQ, is that doing so fosters a suitable environment where trade probability takes precedence. By executing multiple trades of the same commodity, equity or market -- using a constant pattern, trigger and stop mechanism -- that results in a favorable outcome more times than not, sample size, time and probability will essentially do the heavy lifting. In fact, while top traders continually seek a bias, many will operate successfully even without such a bias.

Why Win/Loss % Can Be Irrelevant

Over the years, some have asked for my views on an appropriate win/loss percentage on a trade-specific basis. My response is that while such a percentage may be a valid measuring stick for certain traders and methods, there are many styles for which the win/loss concept is a totally irrelevant tool -- and potentially dangerous, if it places focus in the wrong area.

For example, an intraday trader who prefers to have a position in the market to catch a critical anticipated move can have a ratio far less than 50% and be highly profitable, as is indeed the case for many world-class traders. Consider the following trade sequence for an intraday scalper: 

1. An initial QQQ pullback entry as the market approaches trend support, followed by an immediate trade scratch when changing market conditions render the premise for the entry invalid for a net of $0.00; 
   

2. A re-entry based on a similar premise of the market holding key support, followed by a $0.10 stop when support fails; and 
   

3. A final re-entry upon the market not following through on the trend reversal, followed by a profitable $0.50 exit. In this case, the win/loss % was a mere 33%, with net profits of $0.40.

Now let's do a quick reality check on that sequence.

Is the sequence unrealistic? Not at all, as such a trade-management plan reflects a successful blueprint for effective trading for many, including me. Specifically, positioning for trend reversals, such as those reversing via "cup-and-handle" breakouts, often requires such a style.

Is such a concept only relevant to intraday scalping? Absolutely not. Consider the unfortunate events of Sept. 11, 2001. Many will recall that the Nasdaq was showing numerous signs of turning, just prior to the tragic events. Significant price vs. stochastic strength divergence had developed on the hourly chart, and lesser intraday trends had begun to turn northward. (If you recall, we were actually gapping up early on the morning of 9/11.) Several other indicators, including TM's market bias, were lining up accordingly. Given the resulting market dynamics upon reopening on 9/17, the subsequent downtrend extension and consolidation from 9/17-10/2, and the final turn on 10/3, a similar entry/stop (9/10-9/11), re-entry/stop (9/17), and final entry (10/3 when the daily trend reversal triggered) with many opportunities for profitable exits, reflects a very likely scenario which mirrors the precise sequence illustrated above.

Wouldn't commission costs add up and offset the ultimate gain(s)? Commission costs are undoubtedly a cost of doing business and will certainly increase as trade volume increases. Yet, as commission rates have dropped substantially over the last several years (in some case, 90% reductions from $100 to under $10), the result has been increased profitability for this particular style.

While I'm certainly not advocating or encouraging hyperactive high-volume trading, which clearly isn't for everyone and will increase transaction costs, the key concept is that of simply not missing the forest for the trees. If a trader's ultimate objective is the generation of net trading income over the course of a month, quarter or year through the use of effective trade and risk management, overemphasizing a micro statistic, such as trade-specific win/loss, can result in misdirected focus for some.

Again, these concepts may seem startlingly obvious for some, yet why does it seem that the concept of probability is so neglected and discussed so rarely among trading circles? A few possible answers -- that unsurprisingly, reflect the general undoing of many traders -- may provide clues:

Personal Ego -- Many traders attempt to use the market to satisfy an inner urge to prove themselves above others and are focused on being right, rather than being profitable. While trade successes may very well appear on occasion, consistent and lasting success will likely be highly elusive.

Pursuit of the "Thrill" -- With hype ridiculously rampant in corners of this industry, and with many pursuing trading for the perceived thrill and excitement, such industry illusions can easily result in a misdirected trader's focus being 180° from where focus is necessary. Those misguided are often eventually faced with making one of two decisions: (1) pursue boring consistent profits following probability concepts, or (2) engage in the most expensive thrill ride ever constructed.

Lack of Discipline -- Effective use of probability requires a disciplined approach, a trust in key probabilistic components, such as the chosen pattern, and a recognition of a need to keep the pattern constant even during times where the result of lesser probability may be occurring. Back to our coin example, flipping that coin weighted toward heads, it may very well land on tails three or four times in a row, at which point many traders would simply move on to a different pattern or method and unknowingly remove a required constant.

There has been much written on the subject of probability, of which I've admittedly only scratched a few surface areas. Yet I hope the perspective helps to introduce (or reinforce for some) why and how probability plays such a critical role in the business of continual uncertain speculation.

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