[B]Probability and it’s importance in trading.
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There is frequentist probability and subjective probability. The probabilities we are dealing with are a mixture of the two.
Frequentist probability is what people generally think of when they are told about probability, it the percentage value that an outcome will happen if you repeat something many many times.
Subjective probability is a probability derived from someones personal judgement. They are not based on formal calculations and reflect the persons opinions. In trading this would come about through anticipating news impact on a market. For example buying apple shares prior to a keynote speech where you anticipate a new iGadget to be released.
Primarily in this thread the things being looked at will be from the first type of probabilities. Measurable qualities but with a bit of subjectivity when dealing with price patterns.
Anyway in all theories of probability:
P(True) + P(False) = 100% or 1.
An example of a probability is rolling a die. You have a 1/6 probability of getting a six, or 16.6%.
But what are the probabilities of getting two sixes? This is what is called a successive event.
[B]Successive events:
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To find the probability of successive events you multiply the probabilities together.
So in your die example we wish to know the probability of rolling two sixes in a row. One six after the other.
So we take the probability of the first dice getting a six. 16.6% and we multiply that by the probability of the second die getting a six, also 16.6%.
P(0.166) x P(0.166) = P(0.0275)
So we see that the probability of scoring a double six is 2.75%.
You could apply this reasoning to certain market events. Although the market is not ruled solely by probability it’s worth being aware that things like group psychology and human events influence the market.
Ignoring these influences for the time being with this understanding we can interpret the odds of something repeating itself within our analysis.
[B]Mutually Exclusive Events:
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You add the probabilities together.
What are mutually exclusive events? Two events are independent if the outcome of one event does not change the probability of the outcomes for the next event.
Using die as an analogy again when you roll the first die the outcome of that roll has no impact what so ever on the outcome of the roll of the next die.
So lets say you are rolling die and you want to find the probability of getting one six with two die. You would add the probabilities.
P(0.166)+P(0.166) = P(0.332)
That is to say there is a 33.2% probability of getting one six between the two throws.
[B]Why does this matter?[/B]
Well this is the rule that inspires traders to combine indicators, theories and or patterns. Lets say you have an indicator that when oversold gives a 20% probability of giving you an entry at the low of a move. Lets then say you have another indicator built off of completely different formulae that has a 33% probability of letting you buy the low. Independently those indicators would offer no statistical edge but combined you are given the 53% probability of entering on a low.
Probabilities are just one piece of the pie that make up a successful trading strategy. But in this thread I’ll continue to look at the probabilities of certain approaches and start to eventually combine them into tradable methods based purely on a probabilities alone.
Hopefully this is a little bit more insight into why i’m bothering with this thread.