In Trading Odds Always Change

“The most important thing in gamblin’ is knowing the sixty-forty end of the proposition and knowing the human element. Some folks may know one of ‘em, but ain’t many know ‘em both. I believe in logic. Cut and dried. Two and two ain’t nothing in this world but four.”

Buggy Pearson

One of the greatest poker players in the history of the game.
Dropped out of school at 10 to support his family during the Depression

The longer I trade, the more I think about Buggy Pearson who at the core was a man who understood probabilities, not only in the abstract sense of the word but in the very specific concrete application of the idea.

Let’s say we are trading a strategy that is 70% accurate and has 1:2 risk reward profile. The take profit on this strategy is 10 pips and the risk is 20 pips. Now every single trader who opens up a trade with this strategy fully expects to win 10 pips. After all, why would you bother making a trade if you didn’t think you could take 10 pips out of the market? The truth, of course, is a lot more subtle than that. Your actual win on this strategy is -- Just.One.Pip.

Why?

Well, the weighted probability of this setup is equal to .(70%*10 -30%*20)/10 which is in fact 1 pip per trade. So instead of getting mad when you get stopped out, perhaps even 2 or 3 times in row, thinking in weighted probabilities really helps you get a clearer sense of perspective

You are not meant to win every trade. If you did, the game as we know it could not exist. In fact, when you think about weighted probabilities you begin to understand that that losing is the only thing that allows you to win.

As long as you lose with control.

And here is where the nature of probabilities gets even more interesting. As traders, we know that 90% of good trades have a very small maximum adverse excursion. Good trades pretty much work from the get-go, medium quality trades slip a bit and bad trades almost always fail from the start. Very few of the bad trades recover to hit take profit. Which begs the question -- are the probabilities the same on your 10/20 trade when it is 10 pips against you as they were when you started the trade? Clearly no. We’ve all been there, desperately cheering a trade deep out of the money, hoping against hope that it turns around. It’s essentially the FX version of voodoo. You’ve gone from making a well considered, logical trade to begging for the market Gods to rescue you.

Unless…

You consider dynamically adjusting the odds.

Of course, there are some trades that flush straight to a stop and you just take your hit and move on. But if you think about it -- almost 90% of all bad trades give you a chance to get out with a smaller loss during the lifetime of the trade. That’s why I started working on a concept I call negative profit. If a trade goes more than 50% towards my stop, instead of focusing on the original take profit, I begin thinking about minimizing my loss. In that 10/20 setup I mentioned above, my EA monitors the price feed and if the market slips more than -11 pips against me, it moves the exit to a -5 pip loss. Now a loss is a loss and no one likes losing money, but -5 pips is a lot better than -20 pips and if in a given batch of 10 trades I can turn two -20 pip losers into two -5 pip losers -- well that the same as making 30 pips, because in trading a stop saved is a profit earned.

Of course, you need to do your own research and see if negative profit makes sense in your setup. Generally, that type of structure works best on high probability negative risk-reward trades. But this is just one example of Buggy Pearson’s eternal observation that knowing the odds is not enough. You need to know your current condition because in trading odds always change.

Boris Schlossberg

5 comments

  1. Richard Boer says:

    Great subject! I was also pondering on how to implement this. And indeed many of the losing trades, give you one good opportunity to get out at break even or a small loss. I’m still struggling with the greedy side of me, thinking it will move on towards target. Letting the EA do this for you is a great way to remove the emotional element.

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