From the March 01, 2011 issue of Futures Magazine • Subscribe!

The trader's equation: Should I take this trade?

Improving the third variable — probability — can go a long way toward increasing profit. Probability never can be known with certainty because countless factors affect it. Even with careful testing, a trader might be only 90% certain that a setup has a 60% chance of success. Most traders should not take trades when they believe that they probably will lose. Can a trader make money on a trade where the chance of success is only 20%? Of course, because the trader’s equation has three variables and if the profit target is 16 ticks and the stop is only two ticks, he could make money.

But is a two-tick protective stop ever realistic? Not often, but sometimes it is. If a trader thinks a pullback should not fall below a prior low, a limit order to buy one tick above that prior low with a one-tick stop loss below it might work. If the order gets filled, there may be about a 30% chance of the market forming a double bottom and reaching the profit target without the stop being hit. Finding low risk/high reward opportunities is the key to success.

At the other extreme, is there ever a situation where the chance of success is 95%? Yes. However, that does not mean that the trade is worth taking. For example, if the market is in a strong bull trend and is breaking out of a bull flag, there could be a 95% chance that it will go one tick higher before it falls to below the bottom of the flag. If a trader bought at the market and placed a limit order to exit with a one-tick profit and had a protective stop below the bottom of the flag, maybe 20 ticks away, the chance of success would be extremely high. However, if the trader took the setup 20 times, he would have 19 ticks in winnings but the one 20-tick loser would erase all of those winnings.

Probability analysis

It is useful to think about directional probability. For example, what is the chance that the market will rally X points before falling Y points? If you look at a situation where your risk equals your reward, then you are considering the directional probability of an equidistant move.

Most of the time, it is about 50%. That means that during most of the day, the E-mini has a 50% chance of falling two points before rallying two points or rallying two points before falling two points. As long as you are considering moves that reasonably can be expected, given the average daily range, this is a reliable rule.

There are times when the directional probability may be skewed, and these are the times traders might have an edge. Indeed, there are situations when the directional probability of an equidistant move is 60% or higher. Then there are times when the probability is 60% or higher that the market will go four or more points in one direction before going two in the opposite direction. When traders learn to spot these setups, they have a great mathematical edge and a profitable trader’s equation.

Two common setups occur in strong trends and another in trading ranges.

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