Thinking you ‘know’ what will happen vs understanding probability

Let’s imagine you have just opened and read an email from the stock picking newsletter you subscribe to and see a buy alert for your “favourite” stock. The company is planning to announce its earnings to the market within the next 10 days, and it now has a ‘buy’ recommendation based on a potential positive announcement. You can hardly contain your excitement because you remember the last time the company announced its earnings the stock price shot up like a rocket. You think to yourself there is no way I’m going to miss out on this trade, because you just ‘know’ it will happen again this time around.

You open your charting package and pull up a chart of the stock. You see that until recently it has been rising steadily but technically the stock has now turned down. But hey, you can hardly sleep due to the excitement of placing an order the next day on the hope that the news will be good. You rationalise that the downtrend is only minor and that the expected positive announcement will cause the stock price to rally sharply. You begin fantasising about what you will do with the profit …. holiday, new car, boat.

The above scenario is an example how a trader or investor can take the available neutral information and distorted it to suit his belief about the future price of the stock. Distorting information when making decisions can trigger emotions that lead to costly mistakes.

Ignoring the information displayed in the charts you buy the stock on the open the next day and then watch in disbelief over the next week as the price continues to fall. ‘Nevermind’ you rationalise, ‘it will rally as soon as the earnings announcement is made’. When the announcement does come, it is an earnings downgrade or an earnings upgrade that did not meet expectations and the stock price gets smashed by the market and the capital you have invested in this trade is halved!! So much for trusting your ‘gut’ and ignoring the price action shown in the price chart.

A few mental triggers that can cause a trader to distort neutral and unbiased information:

• A previous trade with a stock that was successful. Association with past experiences in the market is not a good trading trait.
• Following someone else’s advice or opinion that is contrary to the facts.
• Feeling like you ‘need’ to make a successful trade.
• Feeling that everyone, except you, is making a lot of money and picking the right trades.
• Not having a thorough understanding of the strategy you are using.
• Investing with a stock picking mindset rather than a portfolio mindset.
• A previous trade with a stock that was a loser so not doing the trade because it “feels” that the same will occur this time around.
• Believing you know what price will do next so you don’t need to limit your risk.
• Not believing the current price.

The most important skills that a trader and investor can develop are objectivity and consistency. Learning to stay in the NOW and not associate with the past or have an expectation of the future will help the trader to view the market price action objectively as it is unfolding and not as they would hope it to unfold. This is the beginning of understanding that you need to operate in terms of probabilities and does the trade have a reasonable edge to profit, instead of trying to think you know what is going to happen in the markets.

Let’s take probabilities into consideration and look at how important it is to understanding trading as nothing more than likelihood of one thing happening over another. If you can learn to identify your strategy with probabilities you will no longer need to base it on anything else and there will never be a trade that you have to be in.

There is no trader or investor who trades with the right side of the chart filled in. We all have loss trades. But by thinking in terms of probabilities, combined with risk and money management, we can learn to accept that winners and losers and the size of the winners and losers are factored into the probabilities and hence make consistent profits over a large sample of trades and trading events.

As traders and investors we need to understand that the market is a probabilistic environment. By implementing a strategy that has a probabilistic EDGE we are investing with the probabilities in our favour.