Stock Trader Probabilities

Probabilities in Every Stock Transaction

Statistics, Probability, and the Stock Trader

By Dr. Winton Felt

Statistics play a major role in the life of a trader.  For any single trade, chance is a big factor.  Think of the way a gambling casino works.  If a strategy has a 52% probability of working in your favor, you have an almost even chance of making or losing money on an individual trade.  However, you have nearly a 100% chance of being profitable on 1000 trades.  With a good strategy, the odds are weighted in your favor..

The reality of the market is that stocks will break their patterns, they will also decline enough to trigger their stop losses just before they resume their climb, and setup patterns will fail.  Strategies and paying attention to stock market chart patterns can increase the probability of a successful trade, but they cannot guarantee it.  For example, research by R. E. Davis of Purdue University has shown that a bullish symmetrical triangle is profitable 71.4% of the time for an average move of 30.9% over a 5.4-month period.  Sometimes, the pattern will fail and the stock will decline rather than rise.  The data shows only a probability of a gain.

We have done extensive research on stop losses and have found that all stop losses are likely to be triggered “unnecessarily” some of the time.  It is a reality of the market that a stock will sometimes decline just enough to trigger the stop before it reverses direction and reaches a new high.  There is no way to prevent this from happening.  It comes down to probabilities.  When a stock declines enough that the probability of further decline is greater than the probability of a premature triggering of the stop loss, then you want the stop loss to be there for you.  One way you can do this is by using volatility-based stop losses.  Here the stop loss is placed just outside the probable price excursion of the stock as determined by that stock’s pattern of volatility.  Even then, you will have stop losses triggered which hindsight will reveal to be unnecessary.  However, over time, following the process will work to your benefit in a big way.  

Assume that a stock you are tracking has a well defined rising trendline.  You might buy when the stock pulls back to its trendline and place your stop loss 6% below the trendline (assuming you want to avoid an intra-day spike that would trigger your stop).  There is support at the trendline, meaning that buying pressure builds as the stock approaches that line.  Therefore, since the stop loss is placed below the line, it is not likely to be triggered because the buyers at the line will keep the price from falling enough to trigger a sale.  If the stock declines through the trendline, triggers the stop, then reverses course and closes above the trendline, was your thinking wrong?  The answer is no, it was really correct.  You can lose money and still have done the right thing.  The odds were that the stop would not be triggered.  Also, if it were triggered, the odds were that the stock would keep falling rather than reverse course and return to a position above the trendline.       

Most of the time, a drop through support that triggers a stop loss 6% below a well-defined trendline would be followed by additional decline.  Sometimes, it isn’t.  The cost is the commission for selling and buying again, either the same stock or another.  Our own traders at consider such events to be the cost of doing business.  It is the fee we pay the stock market for the privilege of participating.  We also consider those events to be the price we pay for insurance against big losses.  If there were patterns or strategies that gave a certainty of success, people would discover them and the market would cease to function.  There can be no market where every investment is profitable.  There has to be both winners and losers.  Using the tools of fundamental and technical analysis can help you increase the odds of a favorable outcome.  They can help you to be a more consistent winner.  Those who do not use these tools are at a distinct disadvantage in the stock market.  The profitability of buying and selling in the stock market can be seen as a matter of statistics.  All you need to do is shift the probabilities a little so that the odds are in your favor.