I’m sure you have heard many people talk about it before – To succeed in trading, one needs to develop a probability based mindset. But what does that really mean and how can one go about developing this?
If we pick up on previous articles I have written, the first thing a trader should understand is that our brains are pre-programmed to crave and develop a state of certainty. Put in the context of today’s discussion, what this means is our brains are not the best at engaging and assessing probabilities. This is a skill that needs to be developed, and is crucial for your success as a trader.
So what do I mean when I say ‘assessing probabilities’? A probability is simply the change or likelihood of a particular even occurring. It seems simple enough to understand, but in practice our brains are just not hard wired for it.
One particular reason why assessing probabilities is so difficult for us is explained by Daniel Kahneman is his outstanding book ‘Thinking Fast and Slow’. In short, Kahneman explains that our brain operates with two systems, System 1 and System 2. System one is the ‘fast system’ – it is automatic and instant, and very impulsive. We do not ‘think’ when our behaviour is driven from System 1, rather it is almost intuitive. System 2 on the other hand is the ‘slow system’ – this is we are consciously thinking about our behaviour and actions, and thus it takes a bit more time to think over and then implement our choices. Both of these systems are there to help our brain operate more efficiently, making quick decisions when needed and using more resources when required – unfortunately however, in practice our mind is quite lazy and mistakes are often made.
Before scrolling down, answer the following question: A bat and ball are bought together for $1.10. The bat costs $1 more than the ball. How much is the ball?
The majority of people would look at this, and without thinking would immediately come to the conclusion that the bat cost $1, and the ball cost $0.10 – but think about it again…? If the bat cost $1 more than the ball, then the correct answer is the ball cost $0.05 and the bat cost $1.05 (Don’t worry, when I first took this test I fell into the trap as well!)
Basically what happened here was our mind was tricked into taking the easy answer (System 1). It exposed our mental laziness because using System 2 consumes more time and energy. We tend to make choices as quick as possible, even if in reality there is not enough information to come to a complete and rational conclusion.
So how does this relate to trading? Well let me explain. In trading one overwhelming prevalent phenomenon is availability bias. Availability bias is when we tend to assign a probability to a potential result based on the information that is most readily available to us. You are essentially coming up with a quick a seemingly ‘logical’ response to the given information without truly considering all the facts and really thinking about it.
We can use the stock markets in the last couple of weeks as a classic example. Over the last few weeks, many commentators on various social media platforms as well as some big financial TV networks have been saying the same thing – The S&P 500 is approaching the 200 Daily Moving Average, and when this pattern has occurred previously, we have seen a big sell off. Following this, I saw so many people commenting that they were going short. But what happened? The markets have been rocketing, with another huge positive week ending on Friday 15th February 2019.
So what went wrong? Traders were following the herd mentality, yes, but let’s examine a little further. Most people will have made their decisions based on a System 1 decision – Quickly, without much examination and thought and based on the immediate information at hand. They had surface level information that the market would crash, and as a result, they ended up fighting a huge bull trending market (Note I only trade Intraday so my example is in relation to Short Term Trends, however I am sure you would be able to find similar situations over the years across all trader/investor time horizons).
Other examples can be given. For example, System 1 is also used to make decisions in the case of when we revenge trade, or move stop losses etc. “The market is approaching this support, I’ll move my stop below it” or “It’s already fallen so much, I’ll double down on my position, it’s bound to rebound”. Decisions are made quickly and in the moment. None of these trades are taken with an assessment of the probabilities of the outcome. They are in essence, taken blind.
It is clear then where I am heading with this. To really succeed consistently in trading you need to, as mentioned earlier, adopt a probability mindset – and to do this you need to consciously make the effort of using your System 2.
Ask yourself a question – “What is the chance of this trade playing out as planned?”
When you respond to this, it’s important to note that you’re not looking to come up with an arbitrary number, e.g. 60%. What you are looking to do is match up the trade that YOU WANT TO TAKE to a trade that YOU SHOULD TAKE from your trading plan.
Each Trading plan must have a set of defined rules in place for a trade to be taken. These rules should be implemented as a result of rigorous testing of your trading system to ensure that your strategy has a positive expectancy, and that by following your rules your trade will be compliant to your trading plan. Now of course, if the trade is compliant to your plan, then you of course will know that your strategy has a positive expectancy, and thus probability dictates over time you will come out ahead…
Do you see how it all links in…?
The point I want to make is this:
1) Traders need to snap out of the mindset of looking at a probability on an individual trade. No matter how good your system is (let’s say you have a win rate of 80%) – even with such a high win rate, on an individual trade level, it does nothing for you. The result of any individual trade is 50-50. Price will either go up or down from where you entered, it is as simple as that.
2) To truly implement a probabilistic mindset, create a system for yourself to follow before executing every trade. This simple process will automatically ensure you are taking trades using your System 2 thought process, and drastically limiting the trades you take via System 1. It could be as simple as creating a small checklist and physically ticking boxes off before you pull the trigger. Whatever it may be, this simple system forces you to ‘think’ about your next behaviour pattern/action. Simply put, 5 seconds could be all it takes between revenge trading, or just being able to walk away because your checklist wasn’t fully hit. The extra few seconds it took to assess a few ticks enable you to regain control after the rush of blood and impulse you initially felt.
It may sound simple, but sometimes the simplest things are the most effective.
This is an incredibly interesting topic, something that we could discuss for days. If you would like to learn more, then I would highly recommend readers to purchase a copy of “Thinking Fast and Slow” by Daniel Kahneman to further understand the above mentioned systems. You can purchase it direct from Amazon on paperback or kindle here.
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God bless, and happy trading!