Probability vs Certainty – Market Update

I am still surprised at how many people misunderstand one of the basic concepts of trading – probability vs certainty.

Some believe that if they have an unprofitable trade, somehow this increases the chance that their next trade will be profitable.  If they incur a string of losses, they believe that their chance of a profitable trade increases as each unprofitable trade passes.

This is so nonsensical but people believe it.

Many people actually increase their position size after a loss or string of losses in an attempt to regain their losses quickly. In the back of their minds are desperation, and the thought that they need to have a massive winner trade soon to get back on track. Rather, this is a time when they should be even more diligent in ensuring that they scale back their positions and not increase them.

This approach is historically known as a Martingale approach to betting. This notion is to double your bet after each loss, as you think that sooner or later you will have to win. Its application is generally seen in casinos where if you make a bet and lose you double your bet. If you lose again you double your bet again. You keep doing this until you win and then go back to your original bet.

In trading, an anti-Martingale approach is what is needed. After a string of losses, you need to decrease your ‘bet’ to decrease your risk exposure. However, after a series of wins when perhaps your trading method is working well, your position size should increase accordingly.

I often use the example of flipping a coin.  By the way, have you seen this site before?  http://www.virtualcointoss.com/

We know for each toss of the coin, the probability of a head or tail remains at 50% each.

If you have had three losses in a row, the probability that you are going to have a profitable trade doesn’t automatically shift in your favour. Nor does it continue to shift as each losing trade passes. We like to think it does, but it doesn’t. Perhaps we think, ‘The next trade has to be a winner!’ Like the coin, the market has no memory retention and doesn’t keep track of your previous trades in order to influence the outcome of future trades. Each trade is completely independent of any other.

Anyway, to the markets ….

ASX200

The ASX 200 has dropped further again this week and remains below the key 5400 level – currently trading at its lowest level since early July.

There were 17 stocks in the top 500 that achieved new all time highs this week, with 5 at new all time lows.  Would you like a list of these stocks?  Let me know.

One of the current key levels is 5400 (shown below) and this has provided some support earlier this week and it will be watched closely to see if this level can continue to do so.

Image from MetaStock

AUD/USD

The 0.7650 level remains key for the Australian dollar as it rallied earlier this week to back above the level before easing lower again to currently be trading right around it.

I see limited upside as the resistance around 0.7750 seems clear and even a day ago the AUD/USD rallied strongly but was sold off just as strongly from above 0.77.

The other key level remains 0.7500 which has strongly held up the currency and is likely to do so again considering the overall medium term up trend.

As I type this it is trading right around the key level at 0.7650.

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