Thursday, April 12, 2012

Understanding Probability

The market is changing, uncertain, and dynamic, and it is this which changes the underlying probabilities of a situation. As a system trader, I find it helpful to use time frames in order to better understand the probabilities.

I believe the changing cycles of the market affect the underlying probabilities of my trading models in both the short run and the long run. For example, I know that my trading models have a long run 70-80% win rate, but I also know that in any shorter term time frame the probabilities can change. It is not uncommon for me to experience 30-50% win rates within shorter time frames.

The short run probability may be quite different than the long run probability. We see this most clearly when we witness streaks. What is a streak in probabilistic terms? In Tom Stoppard’s play, Rosencrantz and Guildenstern are Dead, Rosencrantz and Guildenstern flip a coin which at one point has landed heads 92 straight times. Guildenstern states, “A weaker man might be moved to re-examine his faith, if in nothing else at least in the law of probability.”

Losing streaks can make us feel like Guildenstern, however, sound money management, risk controls, the passing of time, and most of all faith, can help while we await the reassertion of the long run probabilities.

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