Forex trading is a game of probabilities. Mathematically, the probability that the price of a currency will go up is the same as the probability of it going down. That means it is a 50:50 probability. This knowledge is what is applied in trade point options or binary options pricing.
In this analysis, we want to look at the matter as though we are a computer, which has no way of knowing the effect of news events and happenings around the world on currency prices. With this in mind, we want to explore the effects of luck, chance, probability and sound money management on long term profitability.
Suppose we have 10,000 traders who are trading purely based on chance. Let us also assume that every month, half of those traders are net negative and these are tossed out of the picture, while the other half are net positive and trade again the following month.
By the fifth month, there would be 313 people who have made money each of those months purely by chance. After 10 months, there would be nine people left who have made money 10 straight months in a row, purely by chance. The analogy goes on until there is no one left.
The maxim of this story, is that it is entirely possible to be deceived into thinking that one has mastered trading when in reality, pure chance is at play. But chance will not stand the test of time, as eventually, a blow up comes along.
Employing a positive expectancy on probabilistic currency events allows us in spite of the vagaries of chance, to profit.
Renowned investing and trading coach, Dr. Van K. Tharp, defined positive expectancy by saying that ”over a large number of trades, you should expect to achieve a positive return for each dollar risked”.
For example, in a long run, an even bet on ”heads” in the flip of a standard coin yields a ”zero” expectancy. This is based on two key facts; the probability of profit is an even 50 per cent, and the payoff for ”heads” is equal to the loss when ”tails” is flipped. The formula for this zero expectancy is:
Another way to achieve a positive expectancy is for the payoff for a win to exceed the penalty for a loss. If you were paid $1.20 for each ”head” that was flipped but lost only $1.00 when ”tails” came up, your positive expectancy would be figured as 10 cents for each dollar bet:
Now if we think of the ”heads” as long trades or buys, and the ”tails” as short trades or sells, we can see that on the long run, we will make money anyway even if we loose 80 per cent of the time provided we make more when we win.
Tharp addressed the issue of winning percentages in the November 1997 issue of ”Technically Speaking,” the newsletter of the Market Technicians Association.
In his article, ”Why It‘s so difficult for Most People to Make Money in the Market,” Tharp states, ”Most of us grew up exposed to an educational system that brainwashes us with the idea that you have to get 94-95 percent correct to be excellent. And if you can‘t get at least 70 per cent correct you‘re a failure. Mistakes are severely punished in the school system by ridicule and poor grades, yet it is only through mistakes that human beings learn.
“In fact, in the everyday world few people are close to perfect and most of us who do well are probably right less than half the time. Indeed, people have made millions on trading systems with reliabilities around 40 per cent.”
No comments:
Post a Comment