The Risk of Trading: Mastering the Most Important Element in Financial Speculation

REDUCING VARIABILITY IN EMPIRICAL PROBABILITY

Now that the doom and gloom theories have been set upon us, there are still some methods for using historical data to determine the probability and edge with relative accuracy. To move forward with a trading plan to include trade setups that can be expected to provide edge, we need to review history in order to plan a strategy. The common trading phrase, “Look to the left in order to be right,” applies perfectly here. Its meaning stems from viewing a price chart to determine the next price movement. Let's take a look at some of the concepts that will help detect edge and the amount of advantage on any given trade opportunity.

Continuing with our simple coin toss example, each of the two possible outcomes has an equal probability of occurring. There are only two possible outcomes on any given flip, heads or tails, or whatever imagery lies on your particular coin. No magic here. There is a 50 percent chance of either outcome on each flip. It is expected that 50 percent of the time, heads will come up, and 100 percent of the time heads or tails will result, since there are only two potential outcomes.

What happens to our ability to project future results when there are more than two potential outcomes? Let's expand this probability using two six-sided dice commonly used in the casino game of craps. You do not need to know the intricacies of the game in order to grasp the concept of probable distribution. What you need to understand is ...