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Using probability to predict the stock market

The teacher asked, “How long does it take for a car moving at 100 km/hr to travel a distance of 100 km?”. The student promptly replied, “That’s easy Sir, exactly 1 hour!”. The teacher shouts at him, “Wrong! Did you forget to add the factor of human behavior? What about the traffic jams?” and punishes him.

The student is horrified and why wouldn’t he be?

The teacher was not a maths teacher.

He was a teacher in behavioral economics and we traders fondly call him, “Mr. Market”.

Ok. Nice story. Why is this important to you?

Because in the markets, you are applying mathematics at a practical level and it is very important to understand that human behavior plays a vital role in this.

How?

It takes just 1 trader (yes, just one!) sitting anywhere on the planet with a large enough sell order to negate your system. It doesn’t matter to him even if your reason to buy the stock is based on higher engineering mathematics or quantum physics or jet propulsion technology.

Okay, so what should you do then?

You must learn to understand & work with probabilities. You must integrate your trading system with the concepts of probability.

You must understand that:

  • In a probabilistic environment like the market, your system only keeps the odds in your favour. It can’t predict the future.
  • To predict the future, you must predict the behaviour of each and every market participant on this planet. Not a very likely possibility! (Hint: Try to predict your own behaviour 2 days from now and compare with actual results.)