Probability in Trading
Posted: Wed Apr 30, 2003 10:22 am
Hi everyone,
I have some difficulty in understanding the uses of probability in trading, particularly in some rules which state: never take a trade unless the expected profit is 3 times the expected loss and also with the concept of positive expectancy.
My problem stems from the fact that one cannot precisely know the true probability distribution of the underlying price process even if we have an extremely huge database of historical prices, since we don't have a clear definition for 'huge'. In addition to this, I would think most of the forum members would agree that very few traders (if any at all) has the uncanny ability to predict price movements with an acceptable level of accuracy. Given these points, does this not imply that the rule of taking trades with 3-1 profit potential is like gambling in reality since one is only guessing that the trade is profitable?
Secondly, correct me if I'm wrong, but trading systems are tested for positive expectancy based on historical tests (including out-of-sample tests). Again, even if the test results show a significant positive expectancy, how can we possibly know this will be the case in the future?
At the present, I have come with a simple theory: Confidence in having a positive expectancy in one's system should not really come from historical (statistical) testing, but rather from the philosophy of the strategy.
For example, by following the golden rule of cutting losses and letting profits run, one provides a sound philosophy that 'maximises the chances' of having a positive expectancy for one's system. Of course, one can go into details as to where to cut losses and take profits, but the general idea is there. So in the end, we can never know if our system has positive expectancy, but we can be comfortable and confident if we belief we have a reasonable philosophy that underlies the strategy. I suppose this is the whole business of speculation.
In short, I'm not too sure if trading is in fact a game of probabilities. If this is in fact the case, the benefits of testing the statistical properties of trading systems may be slightly overrated. I hope this issue does not sound too much like academic gibberish. Would appreciate the opinions or criticisms of other forum members on this. Thanks.
I have some difficulty in understanding the uses of probability in trading, particularly in some rules which state: never take a trade unless the expected profit is 3 times the expected loss and also with the concept of positive expectancy.
My problem stems from the fact that one cannot precisely know the true probability distribution of the underlying price process even if we have an extremely huge database of historical prices, since we don't have a clear definition for 'huge'. In addition to this, I would think most of the forum members would agree that very few traders (if any at all) has the uncanny ability to predict price movements with an acceptable level of accuracy. Given these points, does this not imply that the rule of taking trades with 3-1 profit potential is like gambling in reality since one is only guessing that the trade is profitable?
Secondly, correct me if I'm wrong, but trading systems are tested for positive expectancy based on historical tests (including out-of-sample tests). Again, even if the test results show a significant positive expectancy, how can we possibly know this will be the case in the future?
At the present, I have come with a simple theory: Confidence in having a positive expectancy in one's system should not really come from historical (statistical) testing, but rather from the philosophy of the strategy.
For example, by following the golden rule of cutting losses and letting profits run, one provides a sound philosophy that 'maximises the chances' of having a positive expectancy for one's system. Of course, one can go into details as to where to cut losses and take profits, but the general idea is there. So in the end, we can never know if our system has positive expectancy, but we can be comfortable and confident if we belief we have a reasonable philosophy that underlies the strategy. I suppose this is the whole business of speculation.
In short, I'm not too sure if trading is in fact a game of probabilities. If this is in fact the case, the benefits of testing the statistical properties of trading systems may be slightly overrated. I hope this issue does not sound too much like academic gibberish. Would appreciate the opinions or criticisms of other forum members on this. Thanks.