Red or Black? 🎲

[SemperExpeto]

(I posted this on Reddit, but thought it might be something our members here would enjoy and maybe get something out of, so I’m reposting here.)

---

Play a game with me! It’s a game of probabilities, a game of chance. Maybe you’ve heard of it? It’s called roulette. But our game is going to be special.

Our roulette is special because it has no green spots, no chance for the house to have an advantage. There’s only red and black. But wait! There’s more! It also has more black spots than red. It’s got 60 black spots and only 40 red spots!

Man, I like those odds. Black is looking mighty sexy! What’s more, black and red both have the same payout, one to one!!!

Alright, let’s play. I’ll be the house, you be the suckeeeeeerrrr… I mean player! I said player!

So, Red or black?

Seems obvious, right?

Black.

It’s a win!

So what’s your next bet? Red or black?

Well, obviously black, right?

Another win!

And now? Do we change our bet to Red now?

No!!! Of course not! Why would we bet on Red? It’s only a 40% chance! We’re back on Black baby!!!

Spin and … lose.

What?!?! What went wrong? How could this happen? Our analysis was perfect. We looked at each square, we counted each one, we did the math, we weighed the ball, we checked under the table to make sure there were no magnets… we did everything we were supposed to do before we took that bet! How could we possibly have lost?

What do we do now? Maybe we should try a new strategy… a new way to analyze and better predict the outcome. Or maybe we should only bet on Black two times in a row, then Red for one round, then back to Black? Maybe if we add a new tool to help us predict the outcome better, maybe a protractor or micrometer?

So, what did you do wrong on that last bet when it landed on Red? Do you know?

I do.

You did nothing wrong. Nothing at all. And put into this simple gaming format it seems so stupid to even question what went wrong. It’s so obvious. Even though we have a 60% chance to win on Black, we have a 40% chance to lose.

So how should we handle this loss? Again, it’s obvious. Pretend it never happened, trust our system and keep betting on Black!

So why is this probabilities thing so hard in trading? We have our system, we know our probabilities, yet we can’t accept the possibility our trade might lose, even though it’s right there in the numbers! So we blame ourselves, our system, our broker….

STOP IT!

If you’ve got your system and you’ve proven to yourself it has an edge, there are two possible outcomes, the probabilities of each already known.

Winning trade… our analysis was correct.
Losing trade… our analysis was CORRECT.

No, that’s not a typo. A losing trade CAN be the correct trade. All successful traders have losing trades that were the correct trade. Because they know each trade is only a probability and they followed their system.

If you follow your system, each trade IS the correct trade, even the so-called ‘losers’.

Individual trades do NOT matter.

Law of averages is what makes money, not individual trades.

[Johnny1974]

@SemperExpeto

Law of averages is what makes money

You were absolutely right until this point.
The ‘Law of Averages’ is the gamblers fallacy. Perhaps you meant ‘Law of Probability’?

[SemperExpeto]

No, I meant Law of Averages.

Wikipedia: “The law of averages is the commonly held belief that a particular outcome or event will, over certain periods of time, occur at a frequency that is similar to its probability.”

And here, from Wikipedia, same page, is what you are referring to: “The gambler’s fallacy is a particular misapplication of the law of averages in which the gambler believes that a particular outcome is more likely because it has not happened recently, or (conversely) that because a particular outcome has recently occurred, it will be less likely in the immediate future.”

The gamblers fallacy and law of averages is not the same thing. The former is a misunderstanding of the latter.

The gambler sees that the roulette wheel has hit Black 10 times in a row and misunderstands this for a pattern. He believes that this means the chances of it hitting red is getting higher with each spin. It’s not. The next spin (if there was no green) is still 50/50.

In trading, you should have back tested your strategy enough to know it’s probabilities. So, if your using law of averages thinking, not gamblers fallacy, you will accept that each individual loss is not indicative of your systems probability. You will also accept that if you’re on a losing streak that still hasn’t hit your max drawdown seen in back testing, you’re still perfectly fine, because it’s all probabilities. Technically, even if it did exceed your max DD, it’s no guarantee that something is wrong with your system, but at least would be a fairly good sign that you should at least take a pause and do some digging.

However, I do see your point to a degree. Perhaps it would be more apt to quote “Law of Large Numbers” as this more clearing hits on the point I’m trying to make. But then that one is less know and I feel I might need to explain it, just so I don’t leave people scratching their heads.

[tommor]

It’s common for new traders to beat themselves up when they have a losing trade. The education system tells them that a bad mark comes from a mistake and they must do better next time.

So they analyse the charts they used and their decisions microscopically and this usually drives them to look at shorter time-frames, tighter stops, more precise indicators - i.e. deep down the rabbit-hole.

[SemperExpeto]

Exactly. I’m hoping to completely avoid this pitiful, since I am at least intellectually aware of it. But time will tell. I’ll just have to make sure I’m paying close attention to myself.

“Trading in the Zone” by Mark Douglas really seems to help drive this point home.

Another great book for those out there who love to take a look at the mind and don’t mind going a bit deeper, check out “Thinking Fast and Slow” by Daniel Kahneman. Easily in my top 5 favorite books.

[ayodimej1]

Maybe this is definitely the one word i should have heard all long,
“Winning & Loaing Trades - definitely a correct analysis” inasmuch my system had proved to have an edge.

Trust me, i read everything from word to word and it looks like i read one of the secret books of Vatican.