In The importance of understanding probability in trading, we have seen how human behavior plays a very important role in trading.
We have also seen why understanding probability is crucial to be successful in the markets.
Here, we will be discussing the difference between understanding probability Vs truly understanding probability.
This is arguably THE MOST important lesson I have learned as a trader!
So, what is probability anyway?
To put it simply, the probability is the mathematical term for the chance.
What probability tells you?
It tells you, what are the chances of happening of one event over another. For instance, if I toss a coin what are the chances of getting heads up? It is 50%. Right? That is a probability.
So, in a large enough sample(say 100 coin tosses) you are expected to get 50 heads & 50 tails.
Now, the important part to you as a trader/investor is NOT what probability tells you.
It is what probability does not tell you.
Probability does not & cannot tell you the sequence of these heads & tails. It only tells you that there are 50 of each but not in which sequence.
If you are trading a system that is right 70% of the times, in the next 10 trades, you will have 7 winners & 3 losers. That is all you know, but in which sequence is not known.
There are huge implications to the above statement.
- You understand probability, so you know you will have 7 winners & 3 losers in 10 trades.
- So, you are almost sure that you will have 3 losing trades.
- OK. Then why do you feel bad or upset when your stop-loss is hit on these trades?
- If you truly understand probability, where is the reason to be upset? Those 3 losers are to be expected. Right?
If I toss a coin, you call “heads” and a tail comes up.
Do you feel emotionally upset about it? No.
Why? You say, “It is just chance!”
To sum it up;
You truly understand probability in trading when you don’t feel the emotional pain when a trade goes wrong and you can simply say, “It’s just the probabilities in the game! It’s just chance!”