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Managing Risk: Why Forex Traders Need to Understand Probability

   

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It is widely accepted that when you start trading, you never consider the most critical issues to becoming a consistently profitable trader.  Often, all you can think of is how much money you are going to make and how you cannot wait to start.

When it comes to managing risk, an often-overlooked component is probability, or the likelihood of something happening.  Even then, I strongly believe that many traders misinterpret the rules of probability. Some believe that if they have an unprofitable trade, somehow this increases the chance that their next trade will be profitable. If they incur a string of losses, they believe that their chance of a profitable trade increases as each unprofitable trade passes.

Let’s set the scene. Perhaps we have a trading method that results in half of our trades being profits and the other half being losses or close to breakeven. We start with $10 000 and after a few losses, our trading capital has lessened to $9400 (3 × $200 losses in successive trades).

Now, we begin to think that we are behind and need to make up the deficit so we can move forward and begin to make money. As each losing trade passes however, the money we need to make to get back to breakeven (back to the initial $10 000) increases and we have less and less capital to do it with, which places pressure on us to perform.

In this situation, many inexperienced traders will increase their position size after a loss or string of losses in an attempt to regain their losses quickly. In the back of their minds are desperation, and the thought that they need to have a massive winner trade soon to get back on track. Rather, this is a time when they should be even more diligent in ensuring that they scale back their positions and not increase them.

Here is where probability enters the scene. As each losing trade passes, we can easily think that the chance of the next trade being a profit increases significantly. It is too easy to think this and with this in the back of our mind, we can be tempted to increase our trade size to get back to break-even quickly because the chance of the next trade being another loss is not great.

This approach is historically known as a Martingale approach to betting. This notion is to double your bet after each loss, as you think that sooner or later you will have to win. Its application is generally seen in casinos where if you make a bet and lose you double your bet. If you lose again you double your bet again. You keep doing this until you win and then go back to your original bet.

In trading, an anti-Martingale approach is what is needed. After a string of losses, you need to decrease your ‘bet’ to decrease your risk exposure. However, after a series of wins when perhaps your trading method is working well, your position size should increase accordingly.

Looking at the table below, you can see why we would consider increasing our trade size to regain losses.

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Loss   Return needed

10%    11%

20%    25%

30%    43%

50%    100%

75%    300%

90%    900%

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If you lose 10 per cent of your capital, assuming you are left with the remaining 90 per cent, you need to enjoy an 11 per cent gain to return to breakeven. However, the more you lose, the more you need to make back in order to return to break-even.  The gap widens significantly. For example, you may lose only 50 per cent; however, you need to make double that (100 per cent) to return to the initial amount.

Let’s explain this scenario with some numbers. The probability of an event is generally represented as a real number between zero and one, inclusive. An impossible event has a probability of exactly zero, and a certain event has a probability of one.

As we have a proven method that is profitable in half the trades, the probability of having a profitable trade is 0.5. The most common analogy used with a probability of 0.5 is that of tossing a coin. When we toss a coin, the probability that it will land heads up on any given coin toss is 0.5 or 50 per cent, and the same for landing tails. So, if we toss the coin 10 times, we would expect that the result will be five heads and five tails.

There is, however, no guarantee that this will occur. It is possible, for example, to result in 10 heads in a row. The key here is that each coin toss is independent. In other words, the outcome of the next toss is unaffected by previous coin tosses, as the coin has no memory retention.

Let’s assume I am now tossing a coin. I toss the coin once and it lands heads up. For the second coin toss, the probability that it will land heads up again remains at 0.5. The second toss now results in another head — that’s two heads in a row. For the third toss, the probability that heads will come up again remains at 0.5. Guess what? The third toss was also a head — that’s three in a row. Do you know what the probability of the fourth coin toss being a head is? It remains the same probability as the coin landing tails up.

This scenario is applicable in trading.

If you have had three losses in a row, the probability that you are going to have a profitable trade doesn’t automatically shift in your favour. Nor does it continue to shift as each losing trade passes. We like to think it does, but it doesn’t. Perhaps we think, ‘The next trade has to be a winner!’ Like the coin, the market has no memory retention and doesn’t keep track of your previous trades in order to influence the outcome of future trades. Each trade is completely independent of any other.

If you keep in mind the laws of probability, you will see that increasing your position size after a series of losses in order to break even faster is a recipe for disaster. After a few losses, your trade size should be decreased slightly to reflect your diminished trading capital, even though you don’t want to.

Having an effective position-sizing model is essential and, in my opinion, is the most important part of risk management. 

There is another technique we can adopt to assist with this too.  Assume we still have a system that returns an equal number of profitable trades and losing trades. Accepting that managing our risk is critical and that every second trade on average will result in a loss, why not try this idea?

Whatever you determine your position size to be for a trade you are about to enter, halve it.  If your position size is going to be $4600, then make it only $2300 and commit that to the trade. Everything else remains the same and you just leave the remaining $2300 sitting in your account for the moment. You still enter at the same price level and your initial stop loss point is the same.

The key difference is that should your trade not work out and the price moves back to your initial stop loss, you still exit the trade but only lose half your risk amount. This simple modification to your position sizing model contributes greatly towards protecting your capital even further.

The obvious question remains of what to do with the other $2300 that we have left out. Should the trade move in your favour, when your trailing exit has moved to break-even or higher (theoretically your worst-case scenario in the trade is now break-even), add the remaining $2300 into the position.   

From this point onwards, the trade remains the same as if you had committed the entire $4600 at the beginning, and you simply monitor the trade throughout moving your trailing exit when necessary and eventually closing the trade when your trailing exit point or your take profit level is triggered.  

This requires a little more work on your behalf however I believe this is a small price to pay for extra protection.

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Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

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