Why is high probability trading so important?

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Old Mar 2, 2009, 6:24pm   #1
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Why is high probability trading so important?

it is true to say that no money is earned by a trade entry,...it is the exit that determines whether a trade is successful or not. In theory a random entry system with the right risk:reward parametres optimised to the strike rate achieved from the random entry could make money.

it is also true to say that the highest probability trading opportunities occur when a confluence of technical factors come together-and that an emphasis on hi-probability outcome trading should be favoured. Here are the reasons;

1. As stated above you can theortically make money in trading from an arbitrary entry so long as the correct risk:reward strategy is employed and adhered to. Even without an arbritary entry employing say a 3:1 risk:reward ratio on a 33% strike rate (winning trades as a % of total trades) would over any sample of entries, prove profitable. It is rightly said that it is not the entry, but the exit that makes you the money.

But here's the thing...when in a trade it is common to experience discomfort and the body communicates that to our brains, resulting in the all too common response to ending that discomfort...by exiting the trade early. (Our bodys react to perceived dangers by preparing to 'Fight or Flee.' )

In trading a lower strike rate system/methodology there are naturally more losing trades and crucially more consecutive losing trades. Our brains remember past losses and irrationally place more emhasis on them than the winners, resulting in it fearing more losses to come. It's mechanism to protect us from this discomfort is to secrete adrenaline and noradrenaline (which comes from the adrenal glands above the kidneys.) The release of these hormones results in the body increasing the flow of fatty sugars through the liver which causes the feelings of discomfort resulting in a much decreased ability to make objective judegements. To put it another way;

'..Your Neo-Cortex (the thinking part of your brain) shuts down and the survival mechanism in the middle and lower more primitive parts of the brain take over. As a result you can react to things and stop thinking things through rationally. Basic emotions like fear and anger take over from more complicated sophisticated higher function emotions.'

So our ability to adhere to strict risk:reward ratios necessary to ensure overall net profitability with a lower strike rate system is severely impaired with the greater number of losses and consecutive losses with this type of trading system. The greater the consecutive run of losses the greater the impairment, and again, crucially, the less experience/understanding one has of this, the greater the discomfort one might experience resulting in non-adherence with the critical risk:reward ratio.

Further to this, such a consecutive run of losing trades can also interfere with the ability to actually place the next trade when the trading edge presents itself, fearfull of further losses, thus interfering with the natural flow of probability upon which all trading edges rely.

Physical discomfort and Fear are powerful debilitating factors on the ability to profit from a trading edge.

The only effective solution in helping to overcome these potential neurological and physiological barriers, available to inexperienced trader is to seek a trading edge that has a high strike rate over any sample of set-ups. This trading system/methodology achieves that.

In knowing the strike rate of a trading edge, a user can calculate the probability and likely size of any consecutive losing run, (and therefore safely optimise risk/leverage to it.)

A 50% strike rate for example is liable to suffer consecutive losing runs of 6-7, a 33% strike rate liable to experience losing runs of 11+ at some point. A 90% strike rate is liable to experience a consecutive losing run of max 2, more commonly 1, when it occurs.

A user should ensure that if should such a consecutive losing run is encountered it falls within their tolerance for risk/drawdown by optminising their leverage to your trading edge.

Whatever the trading style, a user should;

a. Try and develop/obtain a high probability trading egde

b. Optimise risk/leverage to the strike rate of the trading edge.

2. The second reason to seek a high strike rate trading edge is rate of recovery, the following table shows the recovery needed as a % of the remaining account after drawdown, to re-establish the starting balance. It is clear from the table below that it becomes exponentially more difficult to recover an account to it’s starting balance. The loss of account is more likely with low strike rate trading system/methodologies for the reasons given in point 1 above.

% Loss intial capital % profit required to Recover

3. The third reason why high probability trading is so important is the risk of ruin.

Confidence in a trading edge can be shaken because it's user does not understand it's potential for delivering a consecutive losing run over any given sample and how long that consecutive losing run can be. This in turn can lead to the mis-management of the trading edge re money and risk/reward optimisation resulting in a destabilising run of losses that can result in the trading edge being discarded.

The table below shows the most probable longest consecutive losing run at any given strike rate, that can, and probably will - over any extended sample, occur. Obviously a trading edge with a high strike rate (winning trades as a % of total trades) derived from hi-probability trading opportunities is at less risk of causing the user to suffer a destabilising loss/run of losing trades that might see them discard an other wise potentially profitable edge (over a larger sample,) before the sample has played out. Such a de-stabilising loss can occur by being over-leveraged at the prevailing strike rate of the trading edge, being achieved.

Click the image to open in full size.

Optimising the money and risk/reward parametres such that a trading edge cannot cause a user to suffer destabilising losses that might see them discard an other wise potentially profitable edge is key, -but- having a high strike rate trading edge ensures that one potentially negative eventuality that threatens trading suceess is removed.
I can stand the despair - it's the hope I can't manage (John Cleese - Clockwork.)

Last edited by bbmac; Mar 3, 2009 at 1:44pm. Reason: spelling
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Old Mar 3, 2009, 10:44am   #2
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Trading a 40% win rate system is not impossible if you work hard at it.

The unconscious (primitive) mind must be completely confident that you have a long term valid method of trading and it must be comfortable with the level of risk you are taking (including the risks associated with long losing streaks). Otherwise it will take over and sabotage your trading.

I trade systems that only win around 40% of the time, i am prepared to have 10 losing trades in a row. Sometimes (but thankfully not often) i only get 1 or 2 winning trades out of 20.
Most people are not prepared to trade that way and are not prepared to take 30%+ drawdowns. Most people lose confidence and discipline after 3 losing trades.

Some traders claim to be profitable with systems that win over 60% of the time, even 80 or 90% of the time with at least a 1:1 risk reward ratio. I have never been able to find such directional day trading systems (at least not ones that remain robust for long periods) but if others are really having long term success with such systems then maybe they do exist.

But, as you know already, a high win rate is not required to make money when trading.

People fear losing money. But a trader needs to get their unconscious to the point where they are much more fearful of not following their trading plan and rules than they are of losing money.

Last edited by donaldduke; Mar 3, 2009 at 10:53am.
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Old Mar 3, 2009, 1:49pm   #3
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The basic problem is that the math's behind making money is counter-intuituve to what we're taught from a very young age about success/failure.

Simple example. Which is best:

a) 80% win rate @ £2 per win
b) 60% win rate @ £5 per win
c) 40% win rate @ £10 per win

Most people would plump for either (a) or (b) as they feel like winning ratios (i.e. > 50%). Reality is (c) has the best risk-weighted return.

You understand the maths, you don't have a problem. Knowledge conquers fear every time.
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Old Mar 3, 2009, 1:56pm   #4
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Originally Posted by robster970 View Post
Most people would plump for either (a) or (b) as they feel like winning ratios (i.e. > 50%). Reality is (c) has the best risk-weighted return.
Actually, without also knowing the average loss we can't really make any judgements here.
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Author - Trading FAQs, The Essentials of Trading
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Old Mar 3, 2009, 2:24pm   #5
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Yup very true John.

My own fledgling system is currently operating on an approx 1.4 : 1 losers:winners ratio in terms of number of trades, but still shows a positive return expectancy as the size of the losers:winners is 1 : 2.4

So that only translates into a 42% win rate, which you might expect to yield a negative return unless you saw the other stats. And it's all those other ratios (drawdowns / max profit numbers etc) that I think complete the picture.
"That which doesn't kill me makes me stronger"

Last edited by GammaJammer; Mar 3, 2009 at 2:33pm. Reason: make ratios clearer to read
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Old Mar 3, 2009, 2:44pm   #6
Joined Mar 2005
And frequency,

Expectancy x number of trades = total income.

I'm doing alright on expectancy, but it comes with low frequency unfortunately.
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Old Mar 3, 2009, 3:38pm   #7
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Originally Posted by Rhody Trader View Post
Actually, without also knowing the average loss we can't really make any judgements here.
The point was more to illustrate people's mindset's to perceived success/failure rather than the specifics of whether risk adjusted-win > risk adjusted-loss. As my opening sentence was about the counter-intuitive nature of the math's I'm surprised with your comment which is correct but contextually missing my point.

Considering most newb's take time to adjust to this premise I thought it was important to highlight it.
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