If you are in the trading space for any amount of time you would have no doubt heard that traders need to learn to think in terms of probabilities when looking to make a trade.
For the new trader this is obviously difficult because you look at the charts and have no way to see the probability of price going in one direction over the other.
In order for you to be able to think in probability you have to take the next step in your trading. I will get to that in a moment but for it to have real value we must first talk about where you are now as a trader. Otherwise you might struggle to see the value in making the effort to do the work needed.
When you first start out you are likely trading on hope. You know nothing about stuff like supply and demand, breaks in structure or liquidity grabs, etc.
You just take a trade and hope that the price goes up.
As you experience the markets some more, you tend to trade on market vibe. You hear that there is enthusiasm for price going up and you take trades based on the expectation that price will follow the hype. Or, you see price going up and expect it to keep going up.
As you gain a little more experience you start including indicators and identify support and resistance levels into your trading decisions. But you are still taking trades based on hope and expectation. You are just adding technical tools to supplement your personal judgement. Many of those tools are no better than the opinions of other market participants. ( No, I’m not exaggerating )
Expectations play a powerful role in our day to day life. But for you to gain control of how much expectations will impact your trading we have to learn how to recognise them. Expectations are so normal that most people won’t realise they are acting on expectation unless they make an effort to spot them.
In trading you not only need to find a technical edge you must also create a mental edge too. What I like to call the traders temperament. This is an evolved state where a trader is aware of their psychological feedback and any psycho-mechanical processes that a trader brings to the task of trading. This may include biases, paradigms, heuristics and yes, expectations.
So how can we identify when we are reacting from underlying expectation. Well there is one exercise that you can do to help spot this pervasive problem.
Think of any situation where you felt anxious, annoyed, frustrated or angry. This usually happens because you have a hidden expectation of an uninterrupted state of being or progress. The more you think on this the more you start to realise that you unconsciously create expectations all day, every day. You only recognise them if things don’t go to plan and you have a negative reaction.
Keep doing the above exercise and you will have a level of self awareness that most of the population will likely never have. You will be able to manage your emotional reaction to so much because you will know why you react. You will realise that your negative emotions are not because of external causes but from sneaky games that your mind plays on you. It tells you what outcome to expect when you really have little right to expect it.
With only a little bit of experience in the market we quickly adapt to the same mode of operating from expectation. We use poor or inappropriate information, such as indicators or news, to create little rules that we use to apply expectational thinking. The impulse to do this is so subtle that you won’t realise that it’s happening, for the most part.
Once you have a clear appreciation of how you might trade from expectation and how it impacts your trading can you then appreciate the need to evolve to a better process. This is the point at which you seek out the traders mindset. To think in probabilities.
To have better outcomes you need to become different to who you are today. The old you needs to die for the new you to take your place. The old you is content with things staying the way they are so expect some resistance to change.
Thinking in probabilities will be hard work at first. Instead of hope and unearned expectation you will have to seek out the data that will tell you the probability of a trade setup working in your favour. For that to work you will need to have at least one trade setup to consider. My trusty example of a trade setup to use is the ascending or descending triangle formation. ( link to that article )
So let’s do a comparison between thinking in expectations vs thinking in probabilities.
Let’s say you order an online pizza for delivery from a place you have ordered from many times before. As a general rule of thumb they deliver in about 30 minutes from the time the order is placed. (expectation) If it fails to arrive more than 5 minutes beyond your expectation you might start to feel anxious. In this case you are taking all past examples and applying expectation to this one instance.
When we look at the same delivery example from probability, we map out our past experiences as data points to come up with a set of probabilities. In 1% of cases it turns up within 1 minute of the 30 minute target. In 20% of cases it turns up within 5 minutes of the 30 minute target. And so on. You get the picture. In this case you are taking this one instance and comparing it to all past data points before you attempt to make any judgements.
If you were to place a bet on this instance you would want to consider the likelihood of the delivery turning up within a given timeframe. How much would you wager for it to turn up within 5 minutes compared with, let’s say, 10 minutes of the target 30 minutes.
But wait, there’s more to consider. The 5 minute wager will pay out more than the 10 minute wager but has a lower likelihood of being correct. The 10 minute wager will pay less but has a higher likelihood of paying off. Your task is to practice thinking in probabilities so you can work out how much to wager and in what increments to support the most favourable outcome.
Welcome to the world of trading probability. If you can grasp this skill, along with a few others, then there is a very good chance you will be in the top 5% of traders that thrive in the market.