Thinking in Probabilities

I was a math major in college. My favorite class was Probability and Statistics, taught by Dr. Wolcin. He warned us from the beginning that the final exam was the grandaddy of final exams—that it was really hard, and he would probably end up curving it. He said that if you got a 90%, you were a total stud. I got an 89%. The highest grade in the class was a 99%. You won’t believe what the guy who got a 99% is doing these days.

I think one of the main problems that people run into while trading is that they don’t think in terms of probabilities. They have a deterministic view of the market. The chart says the market will go up; therefore, the market will go up. But you have to think in terms of probabilities, assign expected values to each outcome, and make your decision on that basis.

Estimating probabilities is hard. Sometimes the computer will do it for you—the World Interest Rate Probability (WIRP) screen on Bloomberg will tell you Fed rate hike probabilities based on where interest rate futures are trading. Other probabilities are hard to handicap. How do you figure out the probability that XYZ company will beat earnings? And even if it did, what is the probability that the stock will go up?

I use a combination of probabilistic and deterministic thinking when trading. As you know, I am a sentiment geek, so when sentiment is one-sided, you pretty much have your answer. But the rest of the time, probabilistic thinking should be your guide.

What is the probability that a stock will go from 10 to 5 when it has already gone from 50 to 10? The answer might surprise you.