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Part 2 excerpted from lesson 6 of the upcoming Trade Like a Pro ver.10 course.
Why do good decisions often have bad outcomes? This is especially relevant to trading, where we are constantly making decisions with our own or other people’s money. We do all the necessary analysis, make the right decision, and still can have a negative outcome. The short answer: Because the decision process is not directly related to the outcome. A third factor must be considered — probability. Decision making involves choice and probability together to reach an outcome.
You may or may not have taken statistics in school, but it impacts all decision making. Humans are not wired for probability. We prefer certainty, but little in life is certain, except death and taxes. Some seem to beat the odds with superior performance and a smoother ride through life. Let’s try to discover their secret.
Why is Probability Important?
Probability is the foundation of all decision making. We can improve the quality of our decision by refining successive layers of evidence for and against.
“An edge is nothing more than an indication of a higher probability of one thing happening over another.” – Mark Douglas – Trading In the Zone
Probability is not concerned with the decision we make, but with the conclusion. Probability is what lies in the gap between decision and outcome.
How does Probability Impact Our Decision Process?
You can make the right decision and not get your desired outcome. The reason is at every point in the decision tree there is a choice node and a probability node. You can make the absolute right choice and still have probability give you the lesser outcome. Because anything can happen. The probability may be 70:30 and you have done all your analysis and made the right decision. But probability can fall at any moment on either the 70% side or the 30% side. The important point is to keep making good decisions. The more we follow a rule-based process and make good decisions the greater the odds play in our favour.
“Good decision process and bad outcome is better than bad decision process and good outcome, because the latter reinforces bad decision process, … you eventually go to zero or worse” – Jim Collins, author of Good To Great in an interview on The Knowledge Project
Probability is the secret behind the success of every great trader and investor. Our desire for certainty is offset by the probabilistic reality of uncertainty — anything can happen. The less complete our information and analysis the greater the uncertainty.
“An adverse outcome does not mean you made the wrong decision. It just means that the probabilities that you were considering went against you at critical moments on the decision tree” – Jim Collins
How to Use Probability to Improve Our Trading
By thinking in probabilities professionals remove the expectations that cloud objectivity. To trade like a pro you make decisions based on a set of rules. Baseline rules create a structure that avoids cognitive bias. The structure is probability-based and leads the professional to a series of hypotheticals. The trader is now prepared to act.
Probability favours the prepared professional, who has done the analysis, and calculated the risk. And though the professional has no certainty of any individual trade returning the desired outcome. Over time probability delivers the professional superior results. By reducing risk to a known amount and giving probability time, the odds deliver the desired outcome.
“A trader must have positive expectation to apply proper money management.” – Ryan Jones
The professional has an edge when the odds favour one side of a trade over the other. This edge is explained by the Trader’s Equation:
The probability of a trade reaching a profit target before hitting a protective stop is greater than the probability of the market hitting the stop before reaching the target.
Applying this equation requires repetitive practice. We can not learn if we do not practice. Trading is a meta-skill, like reading is a meta-skill.
“You need to know the alphabet, how letters form words, how words have meaning, how words together have meaning, and so on. So often we focus on the meta-skill and not the sub-skills.” – Maria Konnikova – The Biggest Bluff
Trading is exactly the same. We must focus our attention on the fundamentals and know what to buy. We must focus on the technicals to know when to buy and sell. And most important, we need to know that probability determines whether our desired outcome is now or later. We only have to keep showing up, follow the rules, and repeat the process.
To trade like a pro means to have a rule-based process that identifies the risk and calculates the probability before taking the trade.
Below are the 12 most important concepts in trading from the must read book, Trading in the Zone by Mark Douglas. Ask yourself how many of these are true right now in my life and practice.
Five Truths about the Market – from Trading in the Zone – Mark Douglas
- anything can happen
- you don’t need to know what is going to happen next to make money
- there is a random distribution between wins and losses for any given set of variables that define an edge
- an edge is nothing more than an indication of a higher probability of one thing happening over another
- every moment in the market is unique
Seven Beliefs of Consistency – from Trading in the Zone – Mark Douglas
- I objectively identify my edges.
- I predefine the risk of every trade.
- I completely accept the risk or I am willing to let go of the trade.
- I act on my edge without reservation or hesitation.
- I pay myself as the market makes money available to me.
- I continually monitor my susceptibility for making errors.
- I understand the absolute necessity of these principles of success and never violate them.
If you discover that #4 and #5 under Beliefs of Consistency are not true, you now know the source of your frustration and inconsistency. These are the two most difficult beliefs for investment professionals. As humans we crave certainty and the markets are based on probability.
In Part 7 of the is series we will discuss the Four Most Important Questions to ask to help determine the probability of any trade.