Get a trading edge with Probabilisitic thinking

Imagine you are a caveman meandering through a landscape, you hear a rustle in the bush. “What’s that…?” Your brain kicks into action and provokes a flight or fight response. It could be lunch, or it could kill you!

Your primitive brain makes a really simple judgement and decides that the payoff here for ‘kill you’ is pretty bad, -100% in fact. The pay off for food is there as well, but it can’t offset the negative. So you walk away, cautiously.

The curious thing about this instinct is that it still persists today; in two forms. The first one is how we treat losses, but it also kicks in with how we treat outcomes.

Profits and losses

The first most notable apparition of our primitive mind pervading our modern world is that we treat losses with far more severity than profits. It’s not that we don’t value profits, it’s just that our mind is trying hard to avoid losses.

This was useful many generations ago as it stopped us from getting eaten, but is of less use in the modern world. But it still permeates our thinking.

This thinking manifests itself in a number of ways. Think about how stupid you felt when you made an unexpected loss, but also think about when that person cut in front of you when you were in line or on the road waiting patiently. Perhaps it was just a loss of face when you didn’t put across an argument very well?

Losses come in many forms and humans tend to do what they can to avoid them. When it comes to losses the quickest way to get rid of one is to double your stake and lump on the next good thing of course. Then again………

Most losses can be contained, either by forward-thinking or by managing the pay off on the other side. There is no real need to think about the rustle in the bush being a threat in the modern world, especially when trading. Successful risk-taking is all about a balance of risk and reward. Unless you are totally reckless, then the chance of something that will wipe you out should be a far-off situation and preferably, almost impossible.

When I risk money, it’s purely a question for me of what the potential long-term payoff is and I try to skew that in my favour and repeat. I don’t really care about what happens next. I care about what happens over a very long period of time.

Binary thinking

Another thing that has been transported over the millennia is binary thinking. The thought that there are only two outcomes to an event. Most people struggle to come to terms with an answer that isn’t yes or no and often base their decision on a definitive result. I rarely do.

If a politician said there was a 60% chance a policy would work, they would come under attack as being indecisive or having failed to rigorously think things through. But the fact is, at a fundamental level, that is how the universe works. There are only degrees of certainty.

If you don’t believe me, then look at how people react to the information presented in two forms.

If I give facts and judgement on a trading strategy that are based on years of experience and practice. It will lose to advice that says something along the lines of ‘Win a fortune, get a second income, quickly & easily with this secret Betfair trading strategy’. Instinct and interest are driven by fundamentally different forces. If you really want to win and develop a strategy that works in the long term, you have to go against your feelings. If you want to hand money over to a conman, just run with your instinct.

When people ask me if something will happen, I’ll typically give a probability back. People hate that. I once sat in a business meeting where a business plan was being agreed for the following year and I said we probably have a 70% chance of hitting that number. The MD just wanted a Yes or No, so I replied that I could give a Yes if the number was lower as it would be more certain. Nobody in the room really understood what I was saying.

If you try and tip a sports result, you should also say ‘There is a 65% chance of XXXX’. That would allow the punter to know how certain you are and allow them to bet the edge and manage their staking. But of course, absolutely nobody wants that, so people just nominate an outcome as though it’s a certainty. I suspect this will never change.

When I have written articles for magazines or betting sites, this is what the editors want. They called it ‘actionable content’, I call it duping people into placing an almost certain losing bet. But, of course, telling people what they should be doing isn’t doesn’t drive half as much revenue in the short term. Though I would argue the former produces a better long term scenario for both parties.

The problem with trading

I’ve spent a lot of the last 20 years solving puzzles, mainly in the market, but the latter part of my career has been focusing on the why and how. For that, I’ve looked to psychology.

The problem with trading is that it does the exact opposite of what your mind seeks. You have to deal with uncertain outcomes, with uncertain payoffs which only balance out over time. You have to actively find rustling bushes and stick your hand in with the view that it will get bitten off frequently, but that the bushes where that doesn’t happen will help provide the meat and bones to repair your partially eaten arm.

You have to get used to getting eaten, but avoid your head getting ripped off.

Trading will also nag your binary thinking mode, making you believe with certainly one thing or another when you can’t really know the outcome. This leads to mistakes in judgement. People believe that things can’t happen or definitely will happen.

Neither of those is the correct answer. People migrating from matched betting to trading often struggle with this, looking for some definite answer when one doesn’t exist. Losses hurt, a lot. But trading is full of them and your long-term goal is more or less to welcome them and move on. That’s really hard for people to do!

The beginners curse

I once had a conversation with a new trader. To my surprise, he fed back to me that he felt I was evasive and holding something back. I didn’t hold anything back, the way I described the market was what I had learnt over many years experience and accurately reflected the uncertain feeling you get when you trade properly.

There are no easy answers, just set-up’s, potential payoffs and risk/money management. It’s rare to find somebody that realises this straight off. Usually, they try all sorts of different trading strategies, pay money for stuff that clearly can’t work, then lose a fair bit of money, before returning to more fundamental starting points.

This new trader also spoke to somebody else, who promptly gave him a slam dunk, ‘binary’ trading strategy. It was an, if this then that type strategy, he seemed to quite like it. Of course it was appealing to a new trader, the strategy would win quite often and give anybody using it a nice warm feeling. Unfortunately, the strategy was well known, fundamentally flawed and impossible to profit from in the long term. The initial success had fooled him. It kept his mind happy, but in the long term not his bank balance.

When people show you a ‘shortcut’ to a great strategy, show it to the bin. There are no shortcuts in finding an edge, everybody has a different tolerance to risk.

I kept tabs on this chap for a while and his initial excitement eventually died away, he no longer trades having bust through several banks. I tried to nudge him in the right direction, but I’ve noticed that once somebody has committed to something it’s really difficult to get them to change their mind, backtrack and admit they were wrong.

This is another skill you need to acquire when trading, it’s ok to be wrong. But there is a caveat, sometimes you win, sometimes you learn. That’s how it should be. If you lose examine what when wrong if you could have improved some aspect of what you did. If you do this often enough you gently push yourself forward.

Our poor newbie though just couldn’t do that, he relentlessly pursued this strategy until he ran out of money.

Summary

If you want to know how to get and keep an edge, of course you need a strategy and to put some work in, but my best advice is simple.

Avoid the thought processes that most people go through. Once you identify it, you see it everywhere and see the flaws it produces. When you can see that, you can position yourself in front of flaws. Going back to our bush analogy, it’s like setting a trap. Apart from this trap has a great big sign in front of it saying don’t fall into the trap. But I assure you, there will be a never-ending number of people that will.

When you start thinking differently, some people won’t understand you or your judgements and disagreements are common. But in a market, that’s more or less exactly what you want. If everybody thought the same and did the same thing, nobody would win a penny. A difference of opinion is what makes a trading market! Welcome it, embrace it and when people disagree, learn to get a reassuring feeling about it.

It’s quite enlightening when you can stop thinking like everybody else. You can see the true colour of things, it’s not black and white, or should I say ones and zeros. Taking risk in life, on specific judgements and especially when trading, is much more nuanced than that. It’s a judgement on probabilities, where there is no definitive right or wrong answer.

It’s was a transformative moment for my trading when I discovered this way of thinking and started adapting my trading to take advantge of these flaws. So that’s why I recommened you explore it fully.