Probabilities in Trading

moneyball

So I was watching Moneyball again over the weekend for the 1,2,3,… 231st time and caught some thing I didn’t catch the first 230 times. This idea of gamblers math, of statistics, of probabilities. And now everyone stops reading because they can’t stop laughing that it took me that long to figure it out. Let me try to explain myself.

I always knew there was a connection to trading but just couldn’t put my finger on it.

Is it the idea of never swinging for the fences?

Is it the idea that four singles is the same as a home run? That the home run is obsolete sometimes?

I think those are obvious take aways for trading from this movie but there was something else. There is something else that rings in my ears for days afterwards when I watch this movie now. It’s this idea of not having to be right but just to line up the probablities as best as possible and then believe, or allow, or how ever it makes sense to you. I have talked about this before but it was just an idea that didn’t have any backing from the study of probabilities

Here is a clip from the movie where Jonah Hill is worried about being right and Brad Pitt is more concerned about finding the probability and then asking the most important question “What do you believe”?

So what do I do if trading was never meant to be an exercise in the precise? What if it has to be an exercise in the probable? See one of my biggest problems was taking an indicator and trying to force it into my box. “If the lines cross, that has to be a high probability trade”. And it ate me alive. Why did I always have to be right and have concrete solid evidence that when I did take action it was going to work out? It is a small minded place to operate from and it will hold a person back from advancing in any pursuit.

Matt Lacoco and I have discussed the idea of coin flips in trading recently and then out of nowhere Rob does a podcast on that same concept so I knew something was in the air. And then it went a step further. I was introduced to the idea of “gamblers math” Gamblers math can be defined loosely as “The mathematics of gambling as a collection of probability applications encountered in games of chance and can be included in game theory. From mathematical point of view, the games of chance are experiments generating various types of aleatory events, the probability of which can be calculated by using the properties of probability on a finite space of events”. ummmm ya I guess I would say sometimes your right, sometimes your wrong, just don’t let the wrong hurt as much.

In all seriousness though, what if it’s not about being right, and trading is just doing what is probable and covering your backside from the times that heads is flipped instead of tails? Could it really be that easy? Was I really making it that much harder than it needed to be? Where are the inflection points? Where is it probable to flip a coin and stack the odds just ever so slightly in your favor?

I now look for these places of high probability, not the places where I can be perfect.

I am still struggling with this one, but I know that since I have been putting all of these ideas into practice, I have hit my weekly pip goal on Mondays…

For further reading, please check out this little collection of PDF’s on gamblers math, especially the section on money management.

http://www.bjmath.com/bjmath/thorp/tog.htm

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