The game of probabilities

While this is mainly a business blog, I discovered one fine post from my old blog about investing and I thought I'd share it with you. At the time of publishing this post I felt it might be good idea to talk about the game of probabilities and stock markets (well, I still do). I have no intention to dive deep into this topic. However, I think it would be interesting to look at the market as a game of probabilities. Good poker players use the probability theory all the time. They know what is the % probability that one or another starting hand has won in the past, they know the probablilty of making their hand after the flop and so on. They also consider the probability of someone bluffing, considering how a certain player has played before, how he has done it and how he is playing now.

Firstly, imagine a trader who has no knowledge about the market at all. He chooses a random stock and just makes a bet that the price of this stock will go in one direction, lets say „ in hopes" it will go up. This case the possibility of winning with this trade is 50%. Yes, 50%. Considering he has no idea of the market, no idea of the stock then there’s really no other option – he will either lose or win. No other variables can be brought into play. Lets also say that he holds the stock for a week, 5 days.

And if you view the market like that - if a random guy from a random world has 50% possibility of making profit in a random market then a guy with some knowledge about the stock, about the market, should be able to make right decisions more than 50% of the time. Don't you agree?

You can not not-to-agree. And this, in simple words means, that if your stop losses are always set correctly (eg. in order to win $3 you risk just $1) and you're not too greedy (meaning you don't keep hoping the equity will go up even more and more and m...) once you see you're making profit already, once you have reached your take profit limit.

Lets assume you don't really suck in trading. And lets say you get your decisions right 53% of the time. Your average take profit rate is $1.5 per every $1 you risk (meaning that even though you expected to get $3, you sold before you should have or you felt the stock price won't go up anymore etc), assuming you make 100 trades (just for simple calculations) - 53 trades bring you in $1.5 each (total $79.5). 47 trades lose you money $1 each ($47 each). Your total profit is $32.5. It ain't bad, is it? Even though you only made right decisions 53 times out of 100 and earned just half of what you expected to earn. Don't look at the exact $ amounts here, they are just for illustratuon purposes, but the main point is that independent of the percentages and bad risk-profit ratios your winnings were 1 2/3 of your losses.

So if we're not greedy, not emotional, have a great trading plan and actually stick to you - it is more than possible to become a successful trader.

Another thing - good poker players have three different % that they think about after the flop - what is the % possibility that they currently have a best hand; what is the % possibility that they will make a best hand after the turn and river; what is the % possibility that someone is just bluffing. We can't really bring the same type of % into play when trading. But you could look at it similar to that.

* What is the % possibility that your entry point is the best one within the next hour ( when talking about forex, for example )?
* What is the % possibility that the stock will actually move in your desired direction?
* What is the % possibility that the stock will go as much in the same direction as you expect.
* Additionally you also have your stop loss limits, etc, money you're risking.

I suck in maths so I won't try to generate any kind of formula here, but even though market is a game of supply&demand (or fear and greed, if you want) and psychological factors play a big part in it making market less predictable, you migth be able to take at least some advantage of those percentages. Of course, then you also need to actually have those percentages, possibly generated from similar situations in the history.

Well, just something to think about...