# 441. Thinking in Terms of Probabilities

Successful traders think in terms of probabilities.  Rather than looking at the outcome of a single trade by itself, they view it as merely one outcome among a set of outcomes.  They believe that overall their trading strategy will give them an edge, and allow them to come out ahead if they make enough trades.

Probability theory is concerned with hypothetical outcomes of a process that can be repeated over and over again, forever.  For example, suppose one were to toss a coin an infinite number of times.  There are two possible outcomes: heads or tails.  Thus, if a fair coin were tossed an infinite number of times, one would expect heads to occur 50% of the time and tails to occur 50% of the time.  Since the outcome of one toss is independent of the outcome of any other toss, it is impossible to predict the outcome of any single toss.  However, with a large enough number of tosses, one would expect about half will be heads and half will be tails.

Suppose that you received \$2 each time the coin landed on heads and lost \$1 each time the coin landed on tails.  Assuming that you toss the coin a sufficient number of times, you will come out ahead.  As an interesting exercise, toss a coin 10 times.  You will find that sometimes, you will come out ahead, sometimes you will be behind, and sometimes you will break even.  This happens because 10 tosses are not very many tosses compared to an infinite number of tosses.  The 50/50 chance of obtaining heads is only based on the infinite number of tosses, but you will see the more tosses you make the closer the resulting distribution of outcomes will approach a 50/50 split.

Trading outcomes can be looked at the same way.  If one were to view trading outcomes as tossing a coin, one cannot predict the outcome of a single trade, but across a long series of trades, one could expect a 50/50 split, assuming a trading strategy works at least 50% of the time it is used.

In a purely mathematical sense, it isn’t possible to estimate the odds that a trading strategy is expected to produce a win, since the strategy cannot be repeated an infinite number of times.  The best we can do is use historical data to see how well the trading strategy worked in the past, and assume it will work in the future when similar market conditions exist.  Ideally, historical data should provide evidence that your strategy will give you enough of an “edge” to come out ahead.

Nevertheless, from a psychological sense, it is useful to view the outcomes of trading strategies as independent outcomes in the same way that a coin is tossed over and over again.  It isn’t useful to isolate the outcome of a single trade.  Instead, think of outcomes as just one among a series.  It will take some of the pressure off of you.  You will not tend to think that every trade needs to be a winner, which can be very stressful, and you will be more relaxed if you look at the bigger picture.