[This is part of the series: 9 Rules On How To Become A Trader]
Question: “How do you become a (profitable) trader?”
Answer: “Predict the future.”
Since we know that predicting the future is impossible, maybe the question should be more general:”How can anyone become a profitable trader – when nobody has the ability to systematically predict prices?”
The answer is actually simple.
It is encapsulated in an equation they made me work through in grad school.
The answer is understanding Expected Value.
Expected Value = (P1)*(EV1)+(P2)*(EV2)
For the purpose of trading, we modify this to be:
EV = (Probability of Losing Trade)(Expected Loss on Losing Trade)+(Probability of Winning Trade)(Expected Profit on Winning Trade)
What if to start a trade, you just flipped a coin to decide if you should buy or sell?
You have no idea where prices are going and you are flipping a coin to trade.
I would expect you would be correct about 50% or the time. Right? Prices can only go up and down – and you are just guessing at it.
But you don’t do that do you?
You use a signal (please do not use your gut, never use your gut) – some sort of signal – and with that signal, you enter into a trade with a buy or sell order.
In most cases, a signal will get your profitable trade percentage to somewhere between 40% and 60%. Let’s say 55%, just to pick a number.
Now you are using a signal to trade and you have profitable trades 55% of the time.
This means that you have unprofitable trades 45% of the time – and this is where Expected Value comes into play.
If your average losing trade is -$100, and your average winning trade is $100, over many trades you will average $10 profit per trade:
Expected Value = (45%)(-$100)+(55%)($100) = $10
(And you are a profitable trader!)
If your average losing trade is -$122.22, and your average winning trade is $100, over many trades you will average $0 profit per trade (as this is your break-even point):
Expected Value = (45%)(-$122.22)+(55%)($100) = $0
Even at 50% chance of loss and 50% chance of profit on a trade – the answer is simple: To be a profitable trader, your average loss must be smaller than your average profit:
Expected Value = (50%)(-$100)+(50%)($120) = $10
So, look at you own trading.
What is your chance of loss or gain on a trade? What is your expected loss or gain?
Play with it.
In short, we could say that the best advice – the only advice – to becoming a trader is to have your gains be larger than your losses.
I guess that is why some say there are two rules to trading, the first rule is “Don’t lose money. That’s also the second rule.”