Use of Probability of win and Statistics in Trading
Having an ‘Edge’ and trading vs. Gambling
Gambling: The odds are against you and you have to rely on luck to win. For example, take the lottery. Who makes money with the lottery? Well, it’s used by governments to pay for schools, etc. That means that they make a profit on the lottery. If 1 million individuals pay $1.00 each for a ticket, the only way they can make a profit is by paying out less than $1 million. So, the math for the lottery is such that even if some individuals are lucky, they cannot usually exceed $1 million in total winnings among all winners. So, in other words, buying 1 million tickets yourself with $1 million, you would end up with less than $1 million in winnings, even if you have winning tickets. The math has been done and the probability of the game has been fixed against you.
The operators of the lottery have the ‘edge’ in this game. The only way you could possibly win as an individual is by sheer luck. You would have to randomly get one of the winning tickets. You have no control. You cannot repeat any success (in the rare event that you do win). Most of the time you will lose. Statistically, over time, you will pay far more into the lottery than you get out (if you get anything out).
The same principle is used at the casino. All the games in casinos are fixed at specific win/loss ratios which always favor the casinos (the house has the advantage of the ‘edge’). Sure, they may pay out some large sums occasionally (losses to the casino) to a few people, but they collect small steady sums (winnings to the casino). As long as their income exceeds their expenses, they make money. And with the odds fixed, they do, lots of money. All gambling is set up this way. The house always has the ‘edge’ in all gambling. In reality, this edge does not have to be significant. Even 51% winning and 49% losing will make a casino lots of money over time. It’s a numbers game.
How do you get the edge? What really is an edge?
If you design a trading system, test it and it works to make you money, it should do better than randomly entering trades.
The edge is the percentage advantage you have using your proven trading strategy over randomly entering trades in a market.
For example, My system is able to predict days the market goes up 65% of the time and I can buy that market based on my system. Alternatively, I could enter the market each day using a coin toss, giving me 50% accuracy in predicting correct market direction.
Calculating the edge for this example:
Edge = (percentage of win of system) – (percentage of win of random system)
Edge = 65 – 50 = 15%
If my own system is only as good as a random entry system, I need to change systems or make some adjustments on the edge would be zero. We need an edge greater zero to make a system work.
You don’t really need much of an edge. Even a tiny amount is sufficient. Being able to have 51% winners is enough, giving you an edge of 1%.
Look at the following hypothetical scenario: Continue reading “How to Increase your Probability of win trades”