Probabilistic Thought Process In Currency Trading

This is a trading week that can objectively  exemplify how one can trade using probabilities. With just four (now 3) trading days left, many currency pairs have above average monthly trading ranges.

Lets take EURUSD as an example. The EURUSD pair has completed around 65% of its average monthly trading range already. Therefore, there is still a good probability that EURUSD is going to complete its average monthly trading range towards one side or the other (expanding above the high of the month or below the low of the month). By mere observation, one can tell that the pair has a bullish principal move. It has been moving north(bullish) for the most part of the month. It shouldn’t be hard to observe that. By making another observation we can tell that, as of now, price is sitting way closer to the top of this months range: just grab your fibo tool and connect it from the bottom of the month towards the top of the month and see how price is related to 50% of the range.  With the notion that price has a tendency to fulfill an average range for any given time (day/week/month/year), that there is still time (short amount of time) to fulfill its monthly range, that price is clearly trending up for this month and that price  is currently sitting much closer to the top of the range, it’s easy to assume that the EURUSD pair has an above average probability that it will expand above the high of the month.

As a currency trader, I will be looking only for long trades. I will also be only seeking those trades that truly have the potential to take out the high of the month and expand above it. It simply would make no sense to take short trades because it would mean that I would be trading against the odds previously established by the statistic and probabilistic observations. It would also be regarded as senseless to take trades that had little or no potential of expanding the range. This would mean range trading or trading inside what is regarded as trading inside the noise.

I want to make it very clear that by only taking long trades on EURUSD doesn’t guarantee that all the long trades that are taken will be successful. However, it does mean that you will be taking positions with the odds in your favor: where does price have a higher probability to move to?

I would like to ask the reader to perform the same analysis/observations on the USDCAD pair. How much of the average monthly trading range has the pair covered? Is the main move of the month bullish or bearish? How far price is sitting in relation to the top/bottom of the monthly range? Does the average daily range for USDCAD provide a viable intra day trade that would mean a future monthly expansion?  Once you have answered the previous questions, do the final analysis: Which direction does USDCAD have a higher probability to expand? Should I take LONG or SHORT positions or it doesn’t matter?

Try to do the same with different pairs.

Also, try to fit this thought process with the ‘boat exercise’ posted previously on this blog. A trader, just like the captain of the boat,  must be able to combine as much elements(wind direction/wind speed/distance/timing… etc.)  in his/her favor to have a true edge.

Thinking in probabilities, is an invaluable asset for any trader.  I truly see it as an edge.

You don't really need to draw a single line on your chart to make smart trading decisions. ;-)

Hope you have a blast!

Tossing a Coin and Trend Following

Following on the topic of probabilities, I thought on making a post regarding the relationship between tossing a coin and a trend following system.

Many authors have addressed this particular subject, and I will try my best to share my view on the issue.
The event of tossing a coin is a classic example on how probabilities can be explained.

Every time someone tosses a coin there's 50% chances for head and 50% chances for tail. Nothing new.

The first interesting conclusion is that they are totally independent events.

This simply means that even after tossing a coin 10 times and getting heads in all of these attempts, the next time you toss the same coin ( the 11th attempt), there will be a 50%-50% probability of getting either head or tail.

Now, what is the relationship between these statistic events of tossing a coin and trading?

The act of tossing a coin and analysing its outcomes is what makes the foundation of a sound trend following trading system. For that matter, it is also the foundation for mean-reversion systems. However, for the purposes of this blog, I will focus on trend following systems.

Coming back to the coin toss issue. Whenever we toss a coin repeatedly, the outcome wil not always be H(head) or T(tail) perfectly alternating like the following distribution:

HTHTHTHTHTHTHTHTHT: 50% H - 50% T

In a sequence of 20 tosses, we could have sequences such as:

HTTTTTHHTHTHHHTHTTH: 50% H - 50% T

THHHHHHHHHTTTTTTHHT: 50% H - 50% T

TTTTTTTTTTTTTTTTTTHT: 5% H - 95% T

HHHHHHHHHHHHHHHHT: 95% H - 5% T

The only thing we really "know" is that in the very long term, the distribution will be approximately 50% H - 50% T in average. This is a statistic observation called "The Law of The Large Numbers".

However, it's close to impossible to predict what will be the distribution of events in the very short term. This is why there's a tendency for novice traders to observe short term technical patterns that fall in the statistic observation called: "The Law of The Small Numbers". For example: If a currency pair, for the last two weeks had breakouts on the 30min. bar chart, than, the novice trader, turns this into some kind of law and thinks he has found a true gold mine. Big mistake.

I don't want to get away from the main subject. So lets get back to it.

Trend following strategies 'believe' that the distributions do not alternate perfectly towards the mean as HTHTHTHTHT, on the contrary, these strategies look out for discrepancies in the distribution concentrated in one direction or the other relative to the mean. This is what we call trend.

Therefore, trend followers observe imbalances in events of price they being random or not. Therefore, whenever there's a discrepancy, trend follower jump into the trend until the trend reverts back towards the mean thus invalidating the original trend according to one criteria.

It's up to one's criteria to determine, as a trend follower, to observe these distributions and its imbalances as to guide on: where to enter the market, where to cut losses and where to take profits.

As previously mentioned, I will try my best to post my criteria for trend following trading.

Best,
M.

Trend Following: Buying Into Strength, Selling Into Weakness

I haven't being posting as much due to my lack of actual time in order to prepare something worthy of sharing with fellow traders/followers.

Today, I came across something really worthy of sharing.

Recently, I realized that many traders/aspiring traders lack the kind of reasoning about the game of trading. I am pretty much convinced that trading is truly about the game of probabilities rather than an art. Of course there is a lot of geometry in trading. Of course there are occasions in which a trend line or a particular technical formation will work (or fail) as expected. But even in those cases, one has to play the game of cards only when the odds are clearly in his/her favor. Trading is not that much different from playing a card game such as poker. As a matter of fact, trading has even more information available than a ramdom hand at a poker game.

I observe fellow traders/aspiring traders drawing perfectly fitting trend lines as a mean to give them some sort of certainty about the market and its future fluctuations. In a sense, it's pretty understandable that the human being seeks some sort of certainty or protection: a trend line, for many, is considered as a barrier or a place price has/will respect. Guess what: there will be times (many by the way) at which the trend line will not live to one's expectations. Period.

Instead of basing my trades solely on trend lines or formations (TA in general), I prefer to use these tools as complimentary ones. "Filters" as you may.

In future posts will be showing examples of where/when lines or technical formations can help a lot in the decision process for a particular trade. I will also be showing a few examples on how it's perfectly possible to make above average probability trading decisions.

For now, I would like to share with a you a 7th grade physics experiment/exercise that could elucidate a lot of things.

Lets imagine a sail boat. The sail boat departed from point A in direction to point B. Currently, the sail boat is 65% closer to point B and only 35% close to original point A. If you may, the boat is 65% further from point A and 35% closer to point B. The wind is blowing at 50 km/h in the direction of point B. The captain of the boat has to make a decision right now because it's mid day and he has to make to either shore before dawn.

Q: If you were the captain, would you try to head towards point A or let the boat sail towards point B?

The answer will seem quite obvious to most people. However, this is the kind of thinking that most traders lack: think of this in probabilities. It seem way more probable that the boat would reach point B before it could possibly reach point A.

Now lets try to translate this into trading.

Try to think of points A and B as being the bottom/top of a particular range. For example: A could be the low of a week and B the high of a week. Or A could be the high of a month and B the low of a month.

Try to imagine the wind as being the trend. The trend will be up if, for example, on a H1 chart, price is clearly making HHs and HLs. The trend will be down if price is clearly making LL and HLs. It shouldn't be too difficult to identify on H1/H4 charts if price is trending up or down. A third instance may happen as when price is neither clearly trending up or down. In this case, we could consider the conditions at sea as being WINDLESS!


The speed of the wind or the 'speed' of the trend can be measured by the angle of its slope. The more vertical angle there is in a trend, the more "wind" there is for the boat to sail and/or for price to move.

Now lets go back to the original problem and try to rephrase it into trading terms:

Lets imagine the price of a particular asset. Price departed from point A in the direction of point B. It is clearly making HHs and HLs for the last 9-10 days. Therefore it's clearly in an uptrend. It is a rather vertically inclined slope as observed in the H1 chart. Currently, price is 35% closer to the top (POINT B) of this trend/range and 65% far way from the bottom of this range/trend (POINT A).

Q: If you are a trader, would you rather open a LONG position 'betting' that point B will be surpassed first or would open a SHORT position "betting"that point A will be taken out first?


This is where the corollary: "Buy into strength, sell into weakness" comes into play. Opening positions in the direction of the trend and where price has the most chances of expanding has significant probabilistic advantages over opening trades against the trend and where price has less probabilities of expanding towards.

Trading is not an exact science, therefore a trader will have unprofitable trades at times. However, in the long run, I can guarantee you that you will have a higher odd of being successful at this game if you are able to identify and actually execute only the above average probability trades.

On the contrary, trying to pick tops or bottoms with disregard to probabilities is virtual suicide. Even with the best money management, if one bases his/her trading on potential top/bottom setups, he/she will be doomed to failure.

Knowing where, when and how much thru probability evaluation, is key.

Come to think about it, many of the things we have to deal in our daily lives is directly related to probability.

I recommend that the fellow trader/aspiring trader try to play around with the elements of this particular exercise such as the distance, wind speed, etc as to try to evaluate what he/she considers as being acceptable for picking trades. Just try to visualize that the more elements you have in your favor, the higher the probabilities.

I also drastically recommend that fellow traders/aspiring ones give some more attention to thinking in probabilities than to drawing some perfectly fit lines.

As promised, I will be posting examples of trades taken using the above experiment/exercise and a few using lines as filter or support to a trade decision making process.

The best thing a trader can do for his/her trading is to start thinking in probabilities.