Market Trading Tactics. Guppy Daryl

probability of an event is the ratio of favorable outcomes to the total opportunity set. The difference is important. Calculating the odds compares favorable outcomes to unfavorable outcomes. Calculating probability compares favorable outcomes to all possible outcomes. Leonardo, like many high school students and ‘wanna-be’ traders, had difficulty in understanding the difference. I imagine Cardano dragged the dice out yet again to illustrate the difference.

      The divergence between odds and probabilities appears in the ways the outcomes can be reached. There are 36 possible combinations, or ways, of reaching those 11 results. Column C, favorable outcomes, shows the number of combinations required for each result. Some results, such as number 12, only occur from one group of combinations – six dots and six dots. At the other extreme, number 7 is a result reached by six different combinations. They are 6 + 1, 5 + 2, 4 + 3, 3 + 4, 2 + 5 and 1 + 6. For those who do their mathematics simply, the total number of favorable outcomes is equal to the total opportunity set.

      From these calculations we create a table of probability. It tells us there are six possible combinations that give a result of number 7. This is six out of the 36 combinations available. This ratio of favorable outcomes to the total opportunity set is written as a probability of 6/36. The probability of a 12 occurring is found in just one combination out of the 36 available and written as 1/36.

      We make these calculations because we know the limits of the total opportunity set – lower limit 2 and upper limit 12 – required to produce the total opportunity set.

      At a more complex level we can perform similar calculations for a pack of cards, or for the market. The professional card player knows these probabilities, recognizes them instantly and uses them to his advantage. The trader does the same by recognizing market conditions that tip the balance of probability in his favor.

      In transferring the discussion of odds and probabilities from the dice to the market, we shift from ‘favorable outcomes’ to ‘events’. The father of Modern Portfolio Theory, Harry Markowitz, showed the mathematics required for this is much more powerful than a simple calculation of odds and probabilities. Although we know the effects of these events it is more difficult to attach a value to them. The extent of a rise is theoretically infinite, and a fall is limited only by zero. The total opportunity set is ill-defined so the calculation of probability that looks at the ratio of favorable outcomes to the total opportunity set is difficult, if not impossible, to complete.

      This level of financial mathematics is beyond the scope of our discussion and readers who wish to follow this in more detail should refer to Against The Gods, or Hedge Funds by Richard Hills. Those equipped with the appropriate guidance equipment can make their way through A Treatise On Probability by John Maynard Keynes.

      Extended discussions of risk and probability in wider contexts are found in Taking Risks: The Science of Uncertainty by Peter Sprent and Lady Luck: The Theory of Probability by Warren Weaver. The relationship between odds and probability form the basis of some linked trading and money management approaches. David Caplan in Trade Like a Bookie deals with these types of approaches in detail.

      Difficult or not, the trader needs a rule of thumb to estimate the ratio of favorable outcomes to the total opportunity set – the probability. Chart tools and chart patterns point the way. What tips the balance of probability in favor of a particular outcome depends on market conditions and the section of the market you are trading. The way prices clump together with reduced trading ranges at particular levels suggests outcomes with a higher than normal probability.

      Some trade these clumps for small profits using leverage from options and other derivatives. Equity traders look for trend and break-outs that deliver higher returns. How far does the trend go? This can be calculated using a number of techniques that put the balance of probability in our favor where one outcome is more likely than another.

      We shift the balance of success when our trading strategy is based on moves from clump to clump, capturing a break-out as it happens and taking a profit as it slows. This rule of thumb serves the private trader well.

      Chapter 2

      Messages from the Jungle Drums

      Jungles give cover for the daily battle ‘red in tooth and claw’. In the very best adventure books the battle progress is reported by jungle drums. Our search for trading nuggets in our chosen jungle takes place against a background battle for the bulge.

      Unlike the Battle of the Bulge at Bastogne in December 1944 there are no dramatic explosions, no flickering of artillery on the horizon or screeching tank treads through the fog. During those frantic days the airwaves carried desperate, confused and static-ridden messages reporting the progress of the battle. The modern financial market battle for the bulge is fought by silent proxy with numbers dancing across the screen in dealing rooms, brokerages and on home computers. In this battle, progress is reported accurately by the price bar.

      People make prices and we would like to know what they are thinking today. If many people make many prices at the same level the bulge gives us clues about probability. If we understand how they thought in the past then we have a guide to their future thoughts. We want to buy at today’s prices and sell at a profitable price in the future. Any information that helps to establish the most probable profitable future price is particularly useful so we scan the price bars for messages written by other traders.

      Although most people are more familiar with a line chart as a basic screen or newspaper price plot display, it is the bar chart that provides the best starting point for understanding price action. It shows all the important elements of price action for the selected period. Experienced traders are so accustomed to the bar chart they run the risk of forgetting what it means and miss important clues by stepping straight into complexity and ignoring the simply profitable.