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Stocks & Commodities V. 35:06 (14–19): Gain Probability Index by Mike B. Siroky, MD

Gains vs. Losses

Gain Probability Index

You have to know (or estimate) your probability of gain and gain on each spin of the wheel and since there are six red
your payoff odds before entering a trade, but how do you slots out of every 10 slots, the probability of red — p — is
estimate gain probability and payoff odds? Let’s find out. 0.6 and the probability of black — q — is 0.4. Under these

I
conditions, if you were to bet $2 on red 100 times, you would
by Mike B. Siroky, MD place at risk $200 and you can expect to win $1.00 x 60 wins
Wheel: RVECTOR/BINARY CODE: ALENA AKMETOVA/

and lose $2.00 x 40 losses for a net loss of $20.00. You can
magine a roulette wheel that has six red slots for say that your expectancy for red is -10%.
SHUTTERSTOCK/COLLAGE: JOAN BARRETT

every four black slots. If red comes up, the payoff is
$3 to $2 while if black comes up, the payoff is $4 to
$2. Should you bet on red, black, or not bet at all?
What’re the odds
With the payoff information you know the payoff odds. They
are 3:2 and 2:1. But you also need to know the probability of
Of course, due to chance, there will be some variance of this
result. If you were to do the 100 spins a hundred times, you
could calculate the standard error of the expectancy, which is
the standard deviation/square root of n. For a binomial situ-
ation with more than about 30 trials, the standard deviation
can be estimated as √(npq) where n = number of trials, p is
gain probability, and q is loss probability. In this example, the

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 35:06 (14–19): Gain Probability Index by Mike B. Siroky, MD
MONEY MANAGEMENT
standard deviation is √(100*0.6*0.4)= 4.90 and the standard
error is 4.9/√100 or 0.49. So the 95% confidence limit for wins
would be 60 ± 0.98 or approximately between 59 and 61 and
the 95% confidence limit for losses would be 40 ± 0.98 or
approximately between 39 and 41.
If you were to bet $2 on black 100 times, again you have
risked $200 and you can expect to win $2.00 x 40 wins and
lose $2.00 x 60 losses for a net loss of $40.00. You can say that
your expectancy for black is -20%. The standard deviation is
again √(npq) = 4.90 and the standard error is 0.49.
Clearly, both red and black are poor bets so we should not
bet at all. Betting on red, you can expect to lose 10% of your
capital every 100 trials. Betting on black, you can expect to
lose 20% of your capital every 100 trials. If we had to bet, we
should pick red. In this example, black has the higher payoff
odds, but this is offset by a lower probability of winning and
thus red has the higher expectancy. However, in this example,
both red and black are losing bets and over the long term you
will likely lose all of the money you are willing to risk.
Similarly, you have to know (or estimate) your probability
of gain and your payoff odds before entering a trade, but how
do you estimate gain probability and payoff odds?
Figuring it out
The probability of an event is defined as its likelihood or chance
of occurring, expressed as a ratio between zero and 1. There
are three commonly used methods to estimate probability:
1. Historical performance: Determine the historical fre-
quency of the event of interest and set this equal to its
current probability. For example, to estimate the prob-
ability of winning the state lottery, divide the number
of winning tickets sold in the past by the total tickets
sold in the past. Note that it is assumed prior results will
carry forward into the future.
2. Mathematical modeling: If the event of interest has
a known mathematical model, you can calculate the
probability from the frequency distribution or relevant
equation. For example, flipping a fair coin is often mod-
eled using the well-known binomial distribution.
3. Computer simulation: A computer can run multiple
trials and determine the frequency distribution for the
event of interest (Monte Carlo simulation). However,
computer simulation requires a mathematical model
from which to draw random samples.
For example, assume you will use the binomial distribution
to determine the probability of a winning stock trade. This
requires that several assumptions be met:
1. The results must be binary—either heads or tails, win
or lose.
2. The results must be random—here, the term “random”
is used to mean that the outcome of a trade cannot be
predicted with anything close to certainty.
Copyright © Technical Analysis Inc.
3. The results must be independent, that is, the event has
no “memory.”
However, stock prices rarely act in accordance with the above
assumptions (see The (Mis)behavior Of Markets by Benoit
Mandelbrot in “further reading” at end). Here’s a look at
why not:
1. Daily stock price changes are not strictly binary since
closing prices may be unchanged. Over the last 20 years,
SPY had 41 or 0.8% daily bars that were unchanged
from the prior bar. Over the last 100 years (1914–2014),
the Dow Jones Industrial Average (DJIA) has finished
unchanged 0.58% in more than 25,000 trading days.
In contrast, a coin does not land on its edge at a rate of
one half of one percent, which would be five times in
1,000 flips.
2. Stock price changes are not well modeled by the “fair
coin” analogy, which requires that heads and tails have
equal probability. Over the last 100 years (> 25,000
trading days), I have found that the DJIA has closed up
about 53% of the time and down 47% of the time. For
a sample size of 25,000, the 95% confidence interval
should be from 49.4% to 50.6%. So there is a significant
long-term bias toward gaining days over declining days
(or heads over tails).
Furthermore, the mean daily return is 0.02% while
the median daily return is 0.046%. When the mean
is less than the median, it usually indicates a skewed
distribution and there are more values in the right tail
than the left tail. This is confirmed by a skew reading
of -0.54%. For a normal distribution, the skew should
be zero. A negative skew indicates that there are fewer
values in the left tail than the right.
Finally, and most important, the kurtosis of the daily
returns over the last 100 years of trading in the DJIA
stocks is 22.88; this Excel calculation of excess kurtosis
should be zero for a normal distribution. So this tells us
that there are very “fat tails” that encompass far more
“rare” events than a normal distribution would allow.
3. While the coin has no memory, market prices ap-
parently do have some memory (sometimes called
persistence). There are four possible combinations of
up/down over any two-day period (UpUp, UpDown,
DownUp, DownDown). Therefore, you would expect
two up days to occur 25% of the time and two down
days to also occur 25% of the time. However, over the
past two years, SPY has been up two days in a row 31%
of the time and down two days in a row only 19% of
the time. Over the past 100 years, the DJIA has been
up two days in a row 28.6% and down two days in a
row 23.3%. For three days in a row, there are eight pos-
sible combinations, which means this could occur with
a frequency of 12.5% (or 1/8). In reality, it occurred
in the DJIA series 14.96% while three down days in a
www.Traders.com
Stocks & Commodities V. 35:06 (14–19): Gain Probability Index by Mike B. Siroky, MD

row occurred 11.3%. These results give a p value

< 0.01 by the chi square test. 184.5
184.0
183.5
183.0
182.5

So there is strong evidence of persistence in stock 182.0

181.5
10 Day Period
trades that would not be expected from flipping a
181.0
180.5
180.0

“fair coin.” 179.5

179.0

Clearly, assuming that stock prices will act similarly

178.5
178.0

to a “fair coin flip” will lead to significant error and

177.5
177.0
176.5

this makes it necessary to measure the probability of

176.0
175.5

gain over any time window of interest. This article

175.0
174.5
174.0

will discuss how to develop a simple gain probability

16 Jan 17 Jan 21 Jan 22 Jan 23 Jan 24 Jan 27 Jan 28 Jan 29 Jan 30 Jan 31 Jan 3 Feb 4 Feb 5 Feb 6 Feb 7 Feb 10 Feb 11 Feb 12 Feb 13 Feb

index based on historical performance and investigate

90

STOCKCHARTS.COM
70

its utility for technical analysis.

50
30
10

Gain probability index (GPI) 16 Jan 17 Jan 21 Jan 22 Jan 23 Jan 24 Jan 27 Jan 28 Jan 29 Jan 30 Jan 31 Jan 3 Feb

FIGURE 1: UP DAYS AND DOWN DAYS. For SPY, the more recent 10-day period of the 20
4 Feb 5 Feb 6 Feb 7 Feb 10 Feb 11 Feb 12 Feb 13 Feb

To estimate gain probability, use historical performance trading days shown is highlighted in gray. The one-day RSI shows there are seven up days
over any sample period of time. Plotting a moving and three down days. The 10-day simple moving average is 70.
series of the number of up bars divided by the sum
of up bars and down bars for a time period of n bars
gives you the gain probability index or GPI. Unlike with However, Wilder’s relative strength index (RSI) is widely
momentum indicators, the GPI is not based on the amount of available and provides a means of plotting an indicator that
price change but rather on the number of bars participating in emulates GPI:
price advances compared to the number of bars participating Recall that Wilder’s RSI is:
in price declines.
For a period of n bars with price change <> 0, For n bars, RSI = 100 - 100 / (1+RS) (2)

GPI = 100 * [(number up bars) / where RS = [sum of up change] / [sum of down change].
(number up bars + number down bars)] (1) Suppose n=1, which means only a single bar needs to be
considered. If the bar is down, there is no up change and RS=0
GPI is calculated in several steps: and therefore RSI=0.
If the bar is up, down change is zero so the denominator of
1. For any period of n bars, sum the number of up bars [UP] RS becomes zero. Dividing by zero is infinity, so the charting
and sum the number of down bars [DN]. Unchanged bars software evaluates this as RSI=100. Thus, for a one-bar RSI,
are ignored, so the number of trials is n = [UP + DN] there are only two possible outcomes: RSI = 0 or RSI =100.
2. Find the ratio [UP/n or equivalently, UP/(UP+DN))] Figure 1 shows a chart of the SPY with a one-bar RSI
3. Multiply the result by 100. plotted. The RSI oscillates between zero and 100. During
the 10-day period highlighted, there are seven up days and
three down days. Plotting a 10-day simple moving average
A GPI of 50 means the number of up bars and down bars of the RSI(1) gives a ratio of up days to total days, which in
is equal. The odds of gain versus decline are 1:1, or, the prob- this case is 70. In most software programs, the RSI calcula-
ability of gain is 0.5. tion ignores the unchanged bars just as GPI would. The GPI
The GPI is not available in most software trading platforms. calculation specifically ignores unchanged bars because we
want the probability of wins and the probability of losses to
add up to 1.
The GPI emulates a market
breadth indicator, showing the GPI as a standalone indicator
The GPI is extremely useful by itself since it acts similarly to
percentage of bars participating a market advance/decline indicator, except that it applies to a
(or not participating) in any price specific stock or other tradable asset. The GPI thus emulates
movement over a given period of a market breadth indicator, showing the percentage of bars
participating (or not participating) in any price movement over
time. It also gives the probability a given period of time. Finally, the GPI gives the probability
of a gain versus a loss over any of a gain versus a loss over any given period of time.
given period of time. Figure 2 shows a five-year period of SPY price action along
with a 200-day GPI and a 200-day moving average of price.
Note the following:

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 35:06 (14–19): Gain Probability Index by Mike B. Siroky, MD

1. From March 2012 to mid-2014,

the 200-day GPI stayed well 230
225
above 50. 90 220

2. Peaks in GPI approximately mir-

215
210

ror price peaks with much less lag

205
200

than a 200-day moving average

70 195
190
(dark green). 185
180
3. A major divergence occurred 50
175
170
between GPI and price at the end 165

of 2014 and extended into 2015 as

160
Non-confirm price 155

indicated by the trendline. 30 150

145

4. In November 2015, GPI fell below 140

135
50 well before the early 2016 10
130
125
decline in price. 120

5. GPI resumes its upward trajec-

tory in March 2016, confirming
the crossover above the 200-day
moving average.
115
M A M J J A S O N D 13 F M A M J J A S O N D 14 F M A M J J A S O N D 15 F M A M J J A S O N D 16 F M A M J J A S O N D 14 F
FIGURE 2: GPI AS A STANDALONE INDICATOR. On this five-year chart of SPY, you see the price action along
with the 200-day GPI and a 200-day moving average of price. Note that the lag is much less than that of the
200-day moving average (dark green). Also note the divergence between GPI and price at the end of 2014 and
into 2015 as indicated by the trendline.

Estimating expectancy of
a trade
Recall the roulette wheel from the beginning of this article. We
needed to know both the probability of winning and the payoff
ratio. The GPI gives us an estimate of the probability of a gain
on any trade, but how can we estimate the payoff ratio?
Method 1: Use a spreadsheet over any time period n to find
the ratio sum of up changes/number of up bars and sum of
down changes/number of down bars. In other words, calculate
the average gain and average loss over time period n bars.
The payoff odds are the ratio of average gain divided by
average decline.
Payoff odds = [UP/u] ÷ [DN/d] (3)
where
UP = sum of up price changes and u = number of up bars. DN =
sum of down price changes and d = number of down bars.
Note that n=u+d. This equation can be rewritten as:
Payoff odds = [UP/DN] * [d/u] (4)
Method 2: Instead of using a spreadsheet, apply Wilder’s
RSI and GPI. Recall that Wilder’s RSI is derived from the
total gains divided by the total losses over any given time
period. Therefore,
Substituting equations 5 and 6 into equation 4 gives us:
RSI * (100-GPI)
Payoff odds = (7)
(100-RSI) * GPI
From equation 7 it can be seen that if RSI is higher than
GPI, the payoff odds are going to be higher than 1:1.
Equation 7 provides only an estimate of the true payoff
odds calculated by method 1 using a spreadsheet. This is due
entirely to the fact that RSI by tradition incorporates Wilder’s
smoothing rather than raw data.
Here’s an example. On May 15, 2014 Apple (AAPL) had
a GPI of 50 and RSI of 58 for a period of n=64 daily bars.
The estimated payoff ratio is 58/42 * 50/50 = 1.38. Does that
mean buy, sell, or not trade?
• Expected profit: 0.50 win probability × 1.38 payoff
odds = 0.69
• Expected loss: 0.50 loss probability × 1.00 payoff odds
= 0.50
• Net position: 0.69 - 0.50 = 0.19 profit for every dollar
risked

[UP/DN] = RSI ÷ (100-RSI) (5)

These simple calculations show
For example, if RSI = 75, the UP/DN ratio is 75/25 or 3 to 1.
The second term in EQN 4 is d/u and can be calculated
the power of knowing both the
directly from GPI as: probability of gain and the payoff
odds to calculate expectancy.
d/u = (100-GPI) ÷ GPI (6)

Copyright © Technical Analysis Inc. www.Traders.com

 Stocks & Commodities V. 35:06 (14–19): Gain Probability Index by Mike B. Siroky, MD

In this example, the gain probability

Positive payoff 231 is low at 0.41, but the payoff ratio is 1.5,
making the trade somewhat profitable at
230
90 229

12.5% expectancy.
228
227
Negative payoff
These simple calculations do not consti-
226
225
70
tute a complete trading system. However,
224
223

they show the power of knowing both the

222
221

probability of gain and the payoff odds to

220
50
219

calculate expectancy. By using GPI and

218
217

RSI, this can be determined for any stock

216
30 215

on any day for any time period.

214
213

Expectancy can be calculated as:

212
211
10 210
209
208
E = pb – q (8)
15 22 29 Sep 6 12 19 26 Oct 10 17 24 Nov 7 14 21 28 Dec 5 12 19 27 2017 9 17 23 30Feb 6

FIGURE 3: SPY DURING A RECENT SIX-MONTH PERIOD. The green line is a 16-day RSI and the purple
line is a 16-day GPI. The heavy green line is the 200-day moving average.
Note that even though the probability of winning is only
50%, the payoff on the wins is higher than the drawdown on
the losses resulting in a net positive expected profit of 19%.
Here’s another example. On May 16, 2014 Rackspace Host-
ing (RAX) jumped 17%. For n=64 days, GPI is 41 and RSI
is 51. The payoff ratio is thus 51/49 * 59/41 = 1.50. Does that
mean buy, sell, or not trade?
• E xpected profit: 0.41 win probability × 1.50 payoff ratio
= 0.615
• Expected loss: 0.59 loss probability × 1.00 payoff ratio
= 0.59
• Net position: 0.615–0.59 = 0.125 profit for every dollar
invested or 12.5%.
3.00
GPI vs calculated payoff odds breakeven line
2.00
Probability Ratio
where expectancy is E, p is probability of
gain, q is probability of loss or (1-p), and b
is payoff odds. So p=GPI/100 and q=(100-
GPI)/100 or (1-GPI/100) while b=payoff odds is given in
equation 7. Substituting these quantities into equation 8 and
rearranging terms gives:
E = (RSI / (100 - RSI) - 1) *
(1 - GPI/100) (9)
Keep in mind that expectancy E is not a prediction of future
prices. It is simply a mathematical estimate of what would be
expected to happen if a trade with gain probability (p), loss
probability (q), and payoff ratio (b) were executed multiple
times. There is, of course, going to be some variance around
the expected value.
Combining GPI with RSI
If the simple random-walk model were correct, stock prices
would meander up and down with equal probability and
focus line Start Current
equal step size only to end up where they started. But this
is not the case. Stock prices move up or down over extended
periods of time and these trends are due to two components
of movement—probability of gain, which is greater or less
than 0.5, and the payoff odds greater or less than 1:1. The
probability represents the likelihood the step will occur to
the right or left, up or down. The payoff odds represent the

ratio of step size. These two components may or may not be

in sync. GPI estimates gain probability while RSI estimates
payoff odds. So if both RSI and GPI are above 50 and RSI is
1.00 greater than GPI, the probability of gain is better than 50%
and the payoff ratio is better than 1:1. Both components are
in sync and favor further gains in price. If RSI and GPI are
both below 50 and RSI is lower than GPI, they are in sync to
the downside and a negative expectancy will be found.
0.00 Figure 3 shows SPY over a six-month period ending on
0.00 1.00 2.00 3.00
Payoff Odds February 10, 2017. The green line is a 16-day RSI and the
purple line is a 16-day GPI. The heavy green line is a 200-day
FIGURE 4: PAYOFF AND PROBABILITY. Over a recent 12-month period, for
the SPY, the 10-day average payoff ratio is plotted against the 10-day average
moving average. Note the following:
probability ratio, which is p÷q. The brown line is the breakeven line that denotes
where expectancy = 0. 1. In late 2016, RSI tracked lower than GP indicating a

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 35:06 (14–19): Gain Probability Index by Mike B. Siroky, MD

negative payoff ratio. This changed to a positive payoff
ratio after the November election.
2. RSI has remained equal to or above GPI since Novem-
ber 6, 2016.
3. The six months ending February 10, 2017 produced
a 7.27% gain in SPY. From low to high there was an
increase of approximately 11%.
In Figure 4, the 10-day average payoff ratio is plotted against
10-day average probability ratio, which is p/q, for the SPY over
a 12-month period ending in February 2017. The brown line
is the breakeven line, or where expectancy equals zero. The
green focus line breaks the space into two segments: above
the focus line indicates probability is dominant, below the line
indicates payoff is dominant. Note the following:
2. The graph breaks above the breakeven line on the prob-
ability side.
3. After months of back and forth, the graph breaks into
the payoff side and moves steadily away from the
breakeven line.
Mike B Siroky, MD is a retired surgeon living in Phoenix, AZ.
He has more than 25 years of investment experience and is
particularly interested in quantitative technical analysis.
Further reading
Mandelbrot, Benoit, and Richard L. Hudson [2006]. The
(Mis)behavior Of Markets: A Fractal View Of Financial
Turbulence, Basic Books.

1. The starting point is below the breakeven line, indicating

a negative expectancy.

Copyright © Technical Analysis Inc. www.Traders.com

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