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

Probability trading: The best of both worlds?

For example, over the course of 50 trades, each with a 50% probability of winning, there is a 95% probability that a streak of at least four consecutive winning trades will occur. Furthermore, there is a 77% probability that a streak of at least five consecutive winning trades will occur. It’s these completely random streaks that confuse and mislead the trader into believing that his method is robust and that it is just a matter of time before he will be buying his first island.

Malcom Gladwell asserts in his book, "Outliers," that one common trait among elite performers in all fields of work is the accumulation of at least 10,000 hours of practice or effort. In trading years, assuming six hours a day and 250 trading days a year, it would take at least seven years to reach this milestone. However, the false confidence gained from random early success distorts expectations — often grossly and irreparably — causing the trader to trade more frequently and aggressively than he should.

Another problem with discretionary trading is a bias toward the most recent activity that overshadows many traders’ memories. This unconscious bias seduces them into trading setups that have perhaps worked well of late, but unknown to them, do not present a well-defined historical edge for all types of markets. With inflated expectations of continued success, the overly optimistic trader trades aggressively and beyond his skill level.

In reality, the path to riches is not easy for the discretionary trader. As the market conditions evolve and meander through varying phases of bullishness and bearishness, the trader’s results often will vary dramatically from feast to famine. All too often, the seductive ebbs and flows of the trader’s account end with total frustration, or worse, a margin call by his broker.

To summarize, the challenges of discretionary trading include:

  • Difficult to discern excellence and skill from random results
  • Recency bias can distort chart interpretation
  • Emotions can interfere with proper execution
  • It can take years to achieve consistent profitability

Of course, not all discretionary traders fail. Those who have the capital, confidence and commitment to learn to adapt their techniques to varying market environments ultimately can reap the rewards that most seek, but few attain. And some who do not achieve success will survive long enough to try a different approach: System trading.

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