Trading is a probability game. Every successful trader knows that any trade he executes may bring either profit or loss. In order to assess a statistical advantage of a trading strategy, it is necessary to execute a large number of trades. That is why, it takes a lot of time to understand how efficient your trading is. There will be loss-making trades and you cannot avoid it. However, it is within our power to restrict a negative influence of each loss-making trade on your trading capital.
In this article:
- Essence of profitability in trading.
- Nothing is known beforehand.
- The market has the upper hand.
Essence of profitability in trading.
Many traders have a general understanding of the probability concept in trading, however, all too often they do not quite understand its essence or do not use it in trading to the full extent. Analysis of probabilities, conducted by such traders, is reduced to analysis of statistics of profitable and loss-making trades for a certain period of time.
Quite often this is all they do. Traders do not bother about a thorough study of numbers, which they find in the result of testing trading strategies. However, in order to achieve success in a long-term perspective, it is necessary to understand some basic concepts.
Below are two basic ideas, which relate to probabilities in trading:
- Historical values of the risk-reward ratio cannot be the final measure of future probabilities. These are just forecasted indicators of future probabilities;
- Even if you have an understanding of what the risk-reward ratio of a specific trading setup would be, you are not one hundred percent sure that the next trade would make profit or loss.
The idea of probabilities in trading might confuse you a bit, if you treat it without proper attention. It assumes that your trading strategy was characterized by a certain percentage of profitable and loss-making trades for a selected period of time. However, there are no guarantees that this strategy would be that much efficient in future. You should understand that the market constantly changes and sometimes very rapidly. In any case, the future indicators of efficiency of your trading strategy would differ from the historical values.
Nothing is known beforehand.
You should ask yourself, whether historical market data, used earlier for the market forecasting, could be useful for analyzing the current market situation. For example, imagine that you have analyzed efficiency of your trading strategy on the historical data for several years. The market has been in a trend during this period. But what if the market has changed and moved to the consolidation stage? Do you think it makes sense to rely on the past statistics in this case? Can it provide a clear understanding of the future price movement? Probably not.
It is also necessary to take into account the fact that you cannot guarantee a hundred percent favourable outcome of the trade. A convincing risk-reward ratio may take-off your guard when executing a new trade, which could result in negative consequences for your trading capital.
You do not know for sure what chances for success your next trade has, even if you have a general understanding about what, most probably, would happen in the market. Let’s consider the following situation by way of example. The trading system showed the 1.5 relation of profitable trades to loss-making ones (that is, 60% of the trades were profitable) in a series of 250 trades. However, note that, out of the total number of trades, 100 trades were closed with a loss. It means that, in principle, there could be a situation, when you can have a big series of losses. It is an unpleasant situation, but it really could happen.
Namely that is why it is very important to clearly identify risk parameters for each setup, which you trade, and strictly stand by them. This explains why some traders establish a protective rule, which allows execution of a limited number of loss-making trades in a row.
The protective rule directly depends on the time of trading and is usually applied to the intraday trades. This rule allows stopping the trading for the whole trading session in case of development of a negative scenario. The reasons of why this rule comes into force could be the following:
- The best period of time for trading has finished;
- A certain number of trades have been executed and the trading stops, when a positive result during a trading session has been achieved, independently from their total income;
- The number of loss-making trades exceeded the acceptable maximum.
The ability to manage the trading capital (risk management) is as important in the long-term perspective as the availability of a trading strategy with a trader. The problem is that a human being tends to focus on such things, which are directly in front of his eyes. At some moments, the global vision may become distorted by an immediate urge and belief in a positive outcome of the trade. It takes a pronounced character in those cases when trading decisions are made emotionally and not rationally (in accordance with the risk management rules).
Such cases are characterized with a big confidence of a trader in success of an obviously loss-making trade. Namely due to emotional attachment to a trade, a trader often forgets that each trade is just a part of a series of trades. Development of the attachment to a trade looks about as follows:
- You allow the trade to ‘breathe’ and do not restrict it with a stop loss in accordance with the risk management rules;
- Then you give it even more space to be more confident that this ‘trade of the century’ will not be closed by a stop loss;
- At the end of the day you understand that the trade accumulated a significant loss and pushes your profitability curve into the red zone.
The most disappointing is when the trade is closed by a stop loss directly before the market reverses towards you and achieves the earlier set goals. This would happen from time to time. Sometimes you yourself would close a profitable trade just before the market reverses and rapidly moves against you.
We should note here that the risk-reward ratio and also statistical data in general are not useless, however, everything depends on how we interpret them. People tend to distort or manipulate their perception of reality for supporting their own ideas. Namely this is the reason why it is important to understand the trading psychology.
The market has the upper hand.
A trader may forecast any market tendencies, but the market has its own, often different, opinion in this respect. If a trader does not recognize the probability nature of the financial market and is not ready for situations when the market behaves differently from his forecast, he would hardly manage to stay in this business.
When a trader starts to think that he knows for sure how one or another market situation would develop, it means that he needs to reconsider his views.