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09/11/2010

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What Are The Odds Of Scoring AWinning Trade?
by Cory Mitchell (Contact Author|Biography)
When many of us think of probabilities, the first thing that comes to mind isa coin toss - having a 50% chance at being right on a given toss. Cansomething as simple as a coin toss be applied to the market effectively? Itcan at least provide us with some tools for approaching the markets, and itcan be applied in many more ways than one might expect. A trader'scurrent views of probability could be completely wrong, and could very wellbe why they are not making money in the markets. This article is anintroduction to the probabilities of trading and to a commonly overlookedbut integral part of the financial system -statistics. But don't be scaredoff by the word "statistics"; everything will be explained in plain English andwithout many numbers or formulas.
Understanding the Coin Toss
In the short term, anything can happen; this is why the coin toss is anappropriate analogy for the stock market. Let's assume that at a givenmoment in time the stock could just as easily move up as it could movedown (even in arange, stocks move up and down), thus our probability ofmaking a profit (whethershortorlong) on a position is 50%. While hopefully no one would make completely random short-term trades,we will start with this scenario. If we a have an equal probability of makinga quick profit (like a coin toss), does a run of profits or losses signal whatfuture outcomes will be? No! Not on random trades. This is a commonmisconception. Each event still has a 50% probability, no matter whatoutcomes came prior.Runs do happen in random 50/50 events. A run refers to a number ofidentical outcomes that occur in a row. Here is a table displaying the

probabilities of such a run; in other words, the odds of flipping a givennumber of heads or tails in a row.
Run Length

Chance
1 50%2 25%3 12.5%4 6.25%5 3.125%6 1.5625%Here is where we run into problems. Let's say we have just made fiveprofitable trades in a row. According to our table, which is giving us theprobability of being right (or wrong) five times in a row based on a 50%chance, we have already overcome some serious odds. The odds ofgetting the sixth profitable trade looks extremely remote, but actually thatis not the case. Our odds of success are still 50%! People losethousands of dollars in themarkets(and in casinos) by failing to realizethis. The reason is that the odds from our table are based on uncertainfuture events and the likelihood they will occur. Once we have completed arun of five successful trades, those trades are no longer uncertain. Ournext trade starts a new potential run, and after the results are in for eachtrade, we start back at the top the table,
every time
. This means everytrade has a 50% of working out. (Learn how to illustrate an asset return'ssensitivity read
Find The Right Fit With Probability Distributions
.)The reason this is so important is that often, when traders get into themarket, they mistake a string of profits or losses as either skill or lack ofskill. This is simply not true. Whether a short-term trader makes multiple

trades or an investor makes only a few trades a year, we need to analyzethe outcomes of their trades in a different way to understand if they aresimply "lucky" or if there is actual skill involved. Statistics apply on all timelines, and this is what we must remember.
Long-Term Results
The above example gave a short-term trade example based on a 50%chance of being right or wrong. But does this apply to the long term? Verymuch so. The reason is that even though atradermay only take long-termpositions, he or she will be doing fewer trades and thus it will take longerto attain data from enough trades to see if simple luck is involved or if itwas skill. A short-term trader may make 30 trades a week and show aprofit every month for two years. Has this trader overcome the odds withreal skill? It would seem so, as the odds of having a run of 24 profitablemonths is extremely rare unless the odds have shifted more in his favorsomehow. (Find out if mutual fund managers can successfully pick stocksor if you're better off with an index fund. Read
Is Stock Picking A Myth?
)Now what about a long-term investor who has made three trades over thelast two years and has been profitable. Is this trader exhibiting skill? Notnecessarily. Currently, this trader has a run of three going, and that is notdifficult to accomplish even from totally random results. The lesson here isthat skill is not just reflected in the short term (whether that is one day orone year, it will differ by trading strategy), but will also be reflected in thelong term. We need enough trade data to accurately determine whether astrategy is significant enough to overcome random probabilities. And evenwith this, we face another challenge: while each trade is an event, so is amonth and year in which trades were placed.A trader who placed 30 trades a week has overcome the daily odds andthe monthly odds for a good number of periods. Ideally, proving thestrategy over a few more years would erase all doubt that there was luckinvolved due to a certain market condition. For our long-term tradermaking trades that last more than a year, it will take at least several moreyears to prove that his strategy is profitable over this longer time frame andin all market conditions.