Know Your Odds

I’ve always wondered how it would work if you were to bet your arse in a wager. What would happen if you were to win? How would it pay out? Suppose you had really long odds of 150 to 1. Would they ship a whole load of arses to you? But they wouldn’t be your arse, and that was the stake. So there’d have to be some sort of rudimentary arse exchange rate, and an accepted way to determine the value of different arses for such a bet to be honoured. Of greater concern to those placing such bets would be the method of settlement in the event of losing. I imagine they’d summon you to the bookies and chuckle to themselves while they ask you sarcastically to take a seat…

The UK National Lottery, has been going since 1994 and during that time the odds of winning the jackpot have been around 14 million to 1. But now they’re introducing ten new balls (50-59) they go out to 45 million to 1. If you’re upset about that then you clearly struggle with the concept of probability. Basically, you’re not going to win the jackpot. You never were. And that hasn’t changed.

Why ponce about with stupid odds like that? You can trade with odds better than evens. Knowing the probability of a chart pattern or set up working are critical if you’re going to manage risk. Once again the poor training in these islands for private investors has created an impression that risk is managed by putting your stop loss in the correct place and having a target that is 3 times greater. If your target is highly unlikely to succeed then managing risk would mean not placing that trade at all, and no amount of fiddling around with your stop loss will change that.

Of course market conditions change over time, but there are properly researched ball park figures for the probability of chart patterns. Loads of ‘em. In fact, if you can work out how to program a pattern, you can back test on many platforms like ShareScope, and work out the probability of a fairly tight set of conditions yourself.

Chart patterns, like tips from other people, are often used not as an aid but as an excuse. “Oh I lost money because the ‘elephant and banana’ chart pattern I was shown didn’t work.” No, the money was lost for want of bothering to do the research and find out the probability of the pattern working in the first place. I could accept “Oh I lost money because the ‘elephant and banana’ chart pattern I was shown didn’t work this time, but in back testing it showed a 62% probability of success.” Those are great odds and now a new opportunity should be sought. You will also need to know the max drawdown of a strategy, in other words how many times it is likely to fail consecutively, to ensure you allocate capital accordingly. Risk management is about capital preservation, not about having an excuse when you lose it all.