Many people are often put off when it comes to trading. They often think that trading is gambling – but this couldn’t be further from reality.
Trading is a game of probability. Stack the odds in your favour, and you too can have an edge in the markets.
Is trading gambling?
First, we have to define what gambling is. Simply put, it is risking money on an outcome that has a negative expected result. That is to say, before you even place a bet the odds are already stacked against you.
Yes, a gambler might get lucky and see a return on their investment. However, placing these bets many times over will eventually lead to long term losses.
As a trader you want to avoid being a gambler and trade with a positive profit expectancy.
May the odds be ever in your favourThe Hunger Games
The power of probability & profit
Probability is simply the likeliness of a random event occurring. In order to fully understand probability when it comes to trading, you firstly need to know how to calculate the basic probability of a random event.
For this example, we will calculate the probability of flipping a head in a single coin toss. Let’s run through the maths:
Probability of any event = Number of ways the event can occur / Total number of possible outcomes
Probability of flipping heads = Flipping a head / Total number of outcomes (heads or tails)
Probability of flipping heads = 1 / 2 = 0.5
If we look at the probability of flipping a coin and it landing on heads, the chances of us actually getting it correct and wining would be 0.5 (50%).
Let’s say we add a little bit of money into the mix. For every heads I flip I will receive $1 but for every tail I flip I will give $1 away to my friend Colin.
How much can I expect to make?
With this information, we can now use a “profit expectation” formula to calculate exactly how much profit I should expect to make.
Profit expectation = (Profit scenario) + (Loss scenario)
(Profit x profitability of profit) + (loss x profitability of loss)
($1 x 0.5) + (-$1 x 0.5) = $0
So although, strictly speaking, it is true that it is possible that you will win some money, there is the exact same likelihood that you will lose money.
However, what if I was able to negotiate with Colin that if I won the toss and got heads, he will give me $1, but if I lose, I will only cough up 80 cents.
(Yes Colin is a tad stupid!)
How much can I expect to make now?
($1 x 0.5) + (-$0.80 x 0.5) = $0.10
All of a sudden this little simple game of tossing a coin has taken a bit of a shift and now I’m in a much better position than I was 2 minutes ago. The odds are still the same but I now have a positive expected outcome.
This is the power of probability and profit.
COIN TOSS EXPERIMENT
I encourage you to conduct your own experiment to prove how a winning edge plays out over time. Grab a coin and start flipping!
Playing the long game
Okay, you now have a proven edge, so you’re guaranteed to make money now, right? Wrong.
What you didn’t discuss is how many games you will play.
Let’s say you begin the game by flipping 3 tails in a row. This is a perfectly realistic scenario. Your pockets are now $2.40 down and Colin decides to walk away with his profits! Here we played a game with a proven mathematical edge, yet you still lost money.
This is what traders do all the time.
They have a great strategy with a strong profit expectancy, but they quit, walk away, or change their strategy before the edge has a chance to play out!
The only way you can ensure your edge plays out over time is to keep applying that edge over and over again.
To succeed in trading you have to find that winning edge in the market and keep applying that system.Tweet
You can get lucky and fool the numbers in the short term, but over time and distance, your true profit expectancy will always work through.
How you can beat the odds
There are many ways a trader can beat the odds.
- You can increase your win rate,
- decrease your loss rate,
- increase profit on winning trades or
- decrease losses on losing trades.
Beginning traders make the mistake of waiting for setups which have 60 or 70+% accuracy, trading at 1:1 or 2:1 reward to risk ratios. Sure, mathematically these will make money, but guess what – did you know you could have a system which is 35% accurate which still makes money (and a lot of it) over time?
Many traders put way too much emphasis on the win rate and do not understand that a win rate does not tell you anything about the quality of a system or a trader.
Cut your losses short and let your profits runTweet
You can lose money with a 80% or even with a 90% win rate if a few of your losing trades are so big that they wipe out your winners.
On the other hand, you can have a profitable system despite having win rates of just 50%, 40% or even 30% if you are good at letting winners run and cutting losses short.
It all comes down to your reward risk ratio.
Let’s say you want to place a trade which has the potential to profit you $500. The risk of placing this trade (if the trade goes against you) is $250.
What would the Reward:Risk Ratio be?
Reward / Risk
$500 (profit) / $250 (risk) = 2
When you know the reward:risk ratio for your trade, you can easily calculate the minimum required win rate (see formula below).
Minimum Win rate Formula
Minimum Win rate = 1 / (1 + Reward:Risk)
1 / (1+2) = 33.33%
If we take the previous example of the 2:1 reward:risk ratio, the overall win rate has to be greater than 33.33% to be a profitable trade over the long run.
Take emotion out of it
Gamblers are unable to set themselves apart from emotion. They celebrate their wins and get angry when they lose, leading to poor decision making.
Trading is differentiated by requiring a much higher level of emotional detachment than gambling. You have to develop the ability to look at profitable and loss-making trades in exactly the same light.
Professional traders have no fear in closing out for a loss in the early stages of a trade because they know their edge is profitable over the long run. As a result they are often what is refereed to as “trading in the zone”.
Getting out of a loss-making trade early means they limit the potential damage. Someone with a “gambling” mindset would hang around in the trade and hope for the stock price to change in their favour, which would likely inflict even more catastrophic losses.
The best traders have pre-agreed profit and losses that they get out at, no matter how they “feel” about that particular trade. This prevents emotions such as greed and anger taking over, and makes the process almost automatic.
This is not gambling.
Professional traders know that their systems are tried & tested to make them money . Yes, they may encounter some losses but they also know that they’ll encounter winners which over time far outweigh their losses.
Finding a profitable trading strategy
Strategies do not have to be complicated, however, they do need to be well tested!
Look at developing your own strategy. While there are plenty of longstanding techniques out there, their success has reduced as more and more traders use them to make profits.
As a result, you should take a system and put your own personal stamp on it. Maybe you could try an edge on less conventional stocks, or carve out a particular market niche/industry that you can spot an opportunity in within seconds.
Once you have done enough testing you will be able to develop an array of edges which you know have a positive profit expectancy and can make you money over time.
If you approach the markets without a set of trading rules, you are gambling!Tweet
If you approach the market without a set of trading rules and an understanding of your trading approach, you are gambling! Yes, you can get lucky and could make great profits. However, in the long run, the profits of the “gambling” trader are just short term.
I have created a handy spreadsheet which automatically places 1,000 plus trades for you. Simply enter your win rate percentage, reward:risk ratio and you can see how your trading system plays out over time. Grab the spreadsheet today and start simulating!
Therefore, the key to long term success is creating a set of pre-defined trading plans. These will include items such as: trade entry rules, pre-agreed levels of profit and loss, pre-defined exit points, a range of edges to match specific markets and opportunities and so on.
As a result, if a trade doesn’t meet your agreed requirements you should not enter into it. No matter how you feel about it. Once emotions take over you are reverting to a gamblers mindset.
For that reason, It’s time to stop gambling and start trading with a professional trader’s mindset.
Trading is nothing like gambling. Sure, you can get lucky and win some money. But, in order to be successful at trading you have to develop a system that has been proven to win over time.
Successful traders take emotion out of the situation by being ruthless in cutting losses short and letting profits run. Make sure to never enter into any trade that doesn’t meet your own trading plan requirements.
Don’t let the markets win. May the odds be ever in your favour!
Many Happy Trading,