If you want to be profitable in trading, you have to learn few things about mathematical edge and how can you use it to your advantage
Randomness:
Suppose you and your friend are interested in playing balloon shooting game in nearby carnival, both of you go to the place and pay the fees for playing the game and start shooting. At the end of the 10 games, you have got 5 points and your friend got 5 points. So its a Draw game right?
Lets understand the order of shooting - You - 1 shot, 4 miss, 3 shot, 1 miss, 1 shot and your friend - 3 shot, 2 miss, 1 shot, 1 miss, 2 shot, 1 miss. Do we really care about the order of shooting? Like who shot first etc… who cares, only the final score matters. So, you and your friend continued to play the game and had fun. Most of the times you and your friend were able to score above 5 points consistently.
Now the shop owner says lets change the game rules, each bullet costs you Rs,100 and if you win then you will get Rs,2000 if you lose then you have to pay Rs,1000. You and your friend started to make calculation that we can shoot 5 balloons easily, so it will be 5 wins and 5 loss = 5x2000 - 5x1000 - 1000(10 bullet cost) = Rs,4000. Wow, we can make so easy money.
The Game begins,
You - Win, Win, Loss, Loss, Loss, Loss (stopped playing) → Net Loss = -600
Friend - Loss, Loss, Loss (stopped playing) = Net Loss = -3300
Now, both of you feel very sad that you lost money and think its bad to play with money and do some many things to blame yourself. But why, you have taken a decision to test your shooting skills but it didn’t work as expected. Both of you know that you can shoot five balloons easily but why you could not continue playing and now the order of winning matters for you. You don’t like to see consecutive losses. That’s good for you to find who are and you can happily quit the trading. Only the peoples who can play all the games without worrying about the order of winning and loss can become profitable in trading. Its a very unique skill set required for trading, similar to become successful in any profession.
Mathematical edge
Mathematically, there are only two ways you can become profitable in trading.
1. Fixed Loss trading:
You have to trade with a good risk reward ratio (1:2 or 1:3 etc…). If your stoploss is Rs,1000 then you must book the profit at least Rs,2000. If you are good with booking the stoploss but not the target then its a problem.
Expected winning = Winning% x Profit - Losing% x Loss (Excluding commissions)
For the above shooting game, the calculation is
Expected winning = 50% x 2000 - 50% x 1000 = 500 (Excluding commissions).
With this risk reward ratio, the expectation of winning is 50% of the time but We don’t know after how many trades. The results could be anything, you would have win like this 3/10, 7/20, 15/40, 30/60 and reached the 50% winning rate after 60 trades.
2. Unlimited loss trading:
In this case, you have to learn the gambling strategies like Martingale (google for more gambling strategies for mathematical edge) where the traders keep increasing the amount of risk after each trade so that at least winning 1 trade can become profitable. Most of the option sellers follow this strategy. It is good as long as you have only few consecutive losing trades
For example, you learnt about options buying on expiry day and make 100% profit.
This is the money requirements for each trade based on martingale strategy.
- 1000
- 2000
- 4000
- 8000
- 16000
- 32000
- 64000
- 128000
- 256000
- 512000
if you want to win Rs, 1000 then you need Rs, 10,23000 and you must win at least one time in 10 trades otherwise you will lose everything. Too risky.
Happy Learning !! 