When I was stationed on a nuclear submarine, we had a rule we called the 50/50/90 rule. It was something like this, "if a sailor has a 50-50 shot of guessing something right, there is a 90 percent chance they will get it wrong." This somewhat pessimistic rule has stuck with me ever since, but it was when I started forex trading that it hit me harder than ever before.
As a newcomer to trading, my naive belief was as follows:
"Any given currency pair (substitute, stock, futures contract or what ever your financial instrument of choice is) is eventually going to go up or down. These two possibilities mean that there are 50/50 odds that any given trade will be a win or loss. Therefore, if I set my take profit target and stop loss such that the wins are always bigger than the losses, then in the long run I will make money. For example, let's say I buy 1 stock for $1.00 because I think it will go up. Based on the premises above, there is a 50% chance it will go up and 50% chance it will go down. So I purchase the stock and if the price gets to $1.25 I will close it for the win but if it goes down to $0.90 I will close it for a loss. So if I win, I make $0.25 and if I lose, I am down $0.10. Assuming 50/50 odds for a win or loss, I would make money in the long run."
It didn't take long before reality hit. At first I thought to myself "Wow! Trading is the epitome of the 50-50-90 rule." But then as I continued to ponder why I had experienced so many losing trades, I realized that my belief of 50/50 odds is completely flawed. One could reasonably argue that for any given price movement from one tick to the next, the odds are very close to 50/50 that it will go up or down (of course it could stay exactly the same but that would be followed by a tick up or down at some point). However, this does not mean that there is a 50% chance the price will get to my profit target ($1.25 in the example) before it gets to my stop loss ($0.90) in the example. The truth is that there are an infinite number of ways the price can behave between the time the trade is entered and it either hits the profit target or the stop loss. In the example given, the odds are actually much higher that the stop loss will be hit than the profit target. Then of course you have to factor in the spread or brokerage fee as well. What this means is that without some other input or "edge" (additional information) factored into the strategy, it will be a loser. Traders frequently talk about risk to reward (or reward to risk) ratio. In the example I gave, this was $0.25 to $0.10 or 2.5. This means that the dollar value of the wins is 2.5 times the dollar value of the losses. A number of 2.5 sounds great, especially if the probability of a win is 50% but the reality is that the probability is significantly lower. To make matters worse, the bigger the reward-to-risk ratio gets, the lower the probability of a win. Another thing new traders can tend to overlook is that trading is a zero-sum game. For every winner there is a loser, and there are a lot of smart and powerful traders out there with fancy computers and automated systems. This fact alone should scare the new trader.
So what does this all mean to a new trader? Simply put, trading is not easy, it is very hard. A sound strategy is key to being successful and it takes a lot more than some high school level statistics to develop a winning strategy. It is important to thoroughly vet any assumptions we make and drive out any fallacies like that of 50-50 odds before implementing a strategy.
In my next post, I will talk more about the timing of trade entries and exits as well as the martingale concept. I believe that the single most important factor in a trade is timing. The wrong timing can turn a win into a loss but the right timing may be able to turn a loss into a win.
