# Probability theory in trading

### Basic Probability Theory

But I believe I can make it practical for you and we can learn important lessons from a basic understanding of investment probability. The market cannot be predicted on a daily, weekly, monthly, or yearly basis.

### Developing a Probability Based Mindset for Trading

This is NOT true for longer periods of time; but we will talk about that later. Probability Theory So how do some investment advisors correctly predict short term movements with accuracy? The accuracy will fall with each additional coin flip.

At the end of 10 coin flips the odds are only 1 out of will have predicted every coin flip correctly. Is that person the best prognosticator?

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These are completely random events and the odds were 1 out of the would get ten correct guesses in a row. Investment Probability Although the stock market is much more complex, the same concept applies to investment probability.

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Studies have shown that short term returns in the stock market are random, although with a positive bias. The positive bias is the difference between the coin toss example and the stock market; meaning there will be more positive than negative outcomes over time.

November 23, Today so much advanced mathematics is being used by the Quants you will find it very difficult to understand their trading strategies. Most of them use advanced stochastic calculus in their mathematical models. When you try to understand their trading strategies you just scratch your head as you have no idea what the mathematical formulas mean. So everything is impossible to understand.

If you have enough prognosticators and we do! Unfortunately, people begin to believe the stock market prognosticators are infallible, and more and more people follow their advice.

The more successful the probability theory in trading the greater number of followers. In addition to more followers, investors become more confident in their abilities, and make larger and larger bets.

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After all, the predictor has been correct many times; probability theory in trading must know more than anyone else? Of course, this is incorrect. Inevitably the odds eventually catch up with the prognosticator.

They guess incorrectly, and many people are harmed. But more damage can be done with a few incorrect guesses that all the correct guesses combined. That is because few are following when the prognosticator first starts making predictions.

But at the end many people are following, and many will most likely be taking much larger positions than they were in the beginning. Investment Probability and Value It is easy to become lazy and attempt to follow an investment guru instead of implementing fundamental investing principles.

But there are no short cuts in investing. Any investment philosophy that is going to make you rich quickly is a scheme that will end badly. A basic understanding of investment probability theory will cause an investor to ignore short term market prognosticators and focus on value. Related Reading:.