The Probability Based Trading Way

Probability based trading uses applied mathematics to calculate the likelihood (probability) of a future event occurring using the known parameters of volatility and time. To further explain, volatility is represented as the percentage that an underlying is expected to move in one year. Time is represented as the number of days until expiration of the option being traded.

Of course we often trade options with expiration dates far less than one year. With these known variables, the trader can calculate the expected percentage move for any period of time. By multiplying implied volatility times the square root of the days to expiration divided by 365 we can calculate the expected move. [Expected Move = Price x Volatility x Square Root (DTE/365)] In contrast the statistical approach, commonly referred to as technical analysis, uses data from prior events to predict the frequency of future events.

When a coin is flipped probability clearly states that there is a 50/50 chance of the coin landing on heads or tails each time that it is flipped. In a series of coin flips there is the chance that either heads or tails could consecutively come up multiple times in a row. But as the sample size continues to grow the outcome will come closer and closer to 50% heads and 50% tails. This is verified by the “law of large numbers.”

Statistics on the other hand will report hard data numbers on how many times the coin has come up heads and how many times it has come up tails. Therefore, probability of events occurring equates to probability based trading while statistics which equates to technical and fundamental analysis uses past data as a predictor of future events.

Fundamental analysis looks at samples of past financial metrics to see if the current values are high or low and assumes stock prices will respond in the future in predictable ways. Technical analysis counts the number of times certain price behaviors have occurred in a sample of past data, and assumes future markets will exhibit that specific behavior.

Given the reliability of probabilities and the ability to conclude that probability based trading results will be closer and closer to expectations as the sample size grows it would only seem to dictate that traders would migrate to this style of trading. However, technical and fundamental analysis (statistics) dominates the trading landscape and trading courses.

You are probably asking yourself why technical and fundamental analysis (the statistical method) is so popular given their unreliability in comparison to the reliability of probability based trading. The answer is simple. It is easy to do and has been used for decades.

The probability based approach to trading assumes that in extremely efficient markets that price changes are random. Ironically, statistics can be used to quantify that probability based trading works. Because price changes are random it stands to reason that it is extremely difficult to generate consistent trading profits using statistics (technical and fundamental analysis). Therefore it is much simpler and more accurate to be consistent using probabilities to calculate expected movement as we are solving for a result based on the known variables of time and volatility.

With statistical approaches to trading we only have a statistical representation of past data points and cannot discern when patterns change. In sharp contrast probability based trading is solving for an answer in a formula when the variables are known. It can be concluded that probability based trading “self-adjusts” for changes in price, volatility and time. We can apply the appropriate strategy, with known probabilities, and adjust for Implied Volatility and Time.