If You Think Trading Success is Just a Coin Toss, Think Again - Learn How to Win Consistently!
We debunk this misconception—that a trade can only move up or down, so the chance of winning is equal to flipping a coin
Flipping a coin is a game of probability and you might have come across the statement that the probability of winning in a trade is equivalent to flipping a coin, i.e., the chance of getting the trade right is 50:50, just like there is 50:50 probability of getting head or tail when a coin is flipped. However, we believe that this is a misconception among individuals that a trade can only move up or down, so the chance of trade moving up is always 50per cent and hence, it is very difficult to get the direction of a trade right more than 50 per cent of the time.
In this article, we debunk this misconception—that a trade can only move up or down, so the chance of winning is equal to flipping a coin.
In the illustration above, it is shown why the assumption about two-way movement of price is incorrect. It shows a stock that has been moving sideways for an extended period of time. The price action is confined to the thick box. Nothing has changed at the point shown by the end of the box. The stock price movement shows three possibilities, not two. It may continue to move sideways or move up or down. Here we make an assumption drawn from Newtonian physics. Newton's law says that the object – in this case, the price – will continue to travel in the same direction until it meets an opposing force. Hence, there is 70 per cent probability of the price continuing to move sideways, which leaves only 30 per cent probability for alternative price movement—up or down. Here, we are happy to accept there is a 50 per cent probability of an upward or downward movement. This means that in terms of the total range of price movement, we split the balance 30per cent evenly to derive a 15 per cent probability of a rise in price and a 15 per cent probability of a fall in price of the stock. Market data too vindicates the above probabilities of 70:15:15. But the upward or downward movement will happen only when it meets an opposing force that deflects the direction of the price movement. In market terms, this may be an important news event which has enough force to deflect or change the direction of the trend.
This means it is quite easy to get the direction of a trade right more than 50 per cent of the time. Just by trading in the direction of sideways movement, you have an 85 per cent probability of the price continuing to move sideways or upwards (70 per cent continuation + 15 per cent up = 85 per cent). Thus, there is 85 per cent probability of making a successful trade where the price is equal to or higher than your entry price.
Coming to the second scenario - an uptrend, where we see the trend in one direction, we get a very important change in the balance of probabilities. A sideways pattern is not dynamic. A sloping uptrend is very dynamic. This shows market activity with a crowd of people very interested in buying the stock and this keeps pushing the price upwards.
In a rising trend, the chance of price moving up or down is not 50/50. There is 75 per cent probability of the existing trend continuing. This trend acceleration also increases the probability of a price 'pop' or 'bubble' above the trend line. This is very important.
Unlike the sideways movement in the first illustration, the probability of an upward or downward movement in a rising trend is not 50 per cent of the balance or 15 per cent each way. The probability of a higher price rise remains at 15 per cent, but the probability of a trend reversal—a drop in price—is lowered to 10 per cent. So, the overwhelming balance of probability is 90 per cent in favour of the trend continuing, either at current levels or at slightly higher prices (75 per cent continuation + 15 per cent upwards = 90 per cent). This is the raw power of trend trading.
Pick a stock like this and the balance of probability is overwhelmingly on your side. So, to make a winning trade, select a stock where the balance of probability is 90 per cent weighted towards a continuation of the uptrend.
Now coming to third scenario – a downtrend
Compare any downtrend with an uptrend. The overwhelming majority of downtrends are much faster and swifter, and this changes the balance of probabilities.
A downtrend has 80 per cent probability of continuing and around 15 per cent probability of fall in price at an accelerated speed as panic exacerbates. Combine these and you have a 95 per cent probability of continuation in downtrend (80 per cent continuation of downtrend + 15 per cent panic selling = 95 per cent).
At any point in time in a downtrend, there is only a 5 per cent probability that the trend will stop, reverse and change into a new uptrend.
From the above, we can clearly understand that knowing the balance of probability in market behaviour makes its easy to understand why success in trading is not akin to flipping a coin.