Now, what's different to the way that professional view his trade in the market to the way you view your trades. Let's discuss
But now as we turn the corner and start a new year,
I want to talk to you about a subject that if you fully understand and appreciate the concept,
It will hold you in great stead for 2018 and the subsequent years.
This is by far, the most important topic that I've covered in all my Forex videos.
And I'm also confident in saying that the failure to understand the key principles of what I'm going to explain today is...
...the number one reason why most traders fail in this business. And that's the law of large numbers.
Now, before we go into more detail about the law of large numbers, I want to talk to you about probability.
So come and join me on the whiteboard, and I'll explain further.
Ok so, "probability" .
Probability is basically, the statistical likelihood of an event or events happening at some point in the future.
Now, the easiest way to explain...
...probability to you is using the common example of the coin toss. So for example, if you have an evenly weighted coin, with heads and...
...tails as the two possible outcomes, each has a 50/50 chance of...
...happening. So if you were to toss that coin 10 times,
the laws of probability state you should get 5 heads and 5 tails.
But in reality, you may actually get six heads and four tails. You may get...
seven heads and three tails. You may even get 10 heads and..
...0 tails. Why? Because the sample that you're using here is such a small sample. You're not giving the laws of probability...
...enough time to play out.
Pretty sure, if you toss that same coin 10,000 times,
you're going to get pretty close to a...
50-50
distribution...
...heads over tails. You may get 51 to 49 or or something like that.
That's going to be much much closer to what's expected, because now, the sample has gone from 10 to much bigger population of say,
10,000. You're giving the chance for that probability to play out. So if you put that on a gar for example now.
It's going to look something like this. So here's the ten sample. Now, every time...
...you get a head, will go up. Every time you get a tail, you' go down. To your heads, tail, head, head, head, tail,
tail, tail, head, head, tail. It's gonna look something like that. Pretty, pretty erratic. Not close to the mean of
50-50 at all. If on the other hand,
you toss the coin ten thousand times,
it's going to look much more like...
...that. Much more as expected on a
...50-50 outcome. Why? Because the sample size is so small here, that the outcome is a less predictable. On the bigger sample size...
...the outcome is much more predictable.
So why is this relevant in our trading? Well, it's very relevant!. Now, presumably,
you've got yourself a strategy that you've back tested.
You know what the expectancy is. We know the expectancy on the coin is 50/50. If you've got your stir for strategy,
and you've back tested it, you should know what to expect going forward.
So if you understand the laws of probability you won't be throwing out your strategy...
...just after such a small sample size. You'll be giving it much more time to play out. This forms the very...
basis of the law of large numbers that we're talking about today.
Now, the law of large numbers applies to many different walks of life, not just Forex trading.
Let me give you an example of something you might be more familiar with, like the insurance market.
I'm sure we've all done insurance in the past bit; house insurance or car insurance, life. Look, let's look at a life insurance,
So assume you want to get yourself insured you go to the life insurance company,
and they can ask you for certain information. You might say, I'm 50 years old.
I'm an a male,
nonsmoker, and
quite a healthy lifestyle. So the insurance company , now,
they employ a group of people called actuaries. Now, the actuaries job is to go back and look at the big population,
and to come up with a statistical likelihood of where you're back where you're likely to live to. So, for example,
they might come back and say,okay with all those details. You're likely to live to...
86 years old.
Okay, and they will price the insurance policy with that in mind.
In reality,
you may die...
...at 52 years old.
You may live to 100 years old.
The point being here is, the insurance company isn't going to throw out all those past medical history,
all that big population that they've been researching over the years, just because they got one wrong. In reality, chances...
...are you won't die at 86 years old. This is just a big population...
...likelihood. So the law of large numbers says, don't worry about the short term.
Don't worry about minor fluctuations from what's expected.
But keep with it because the law of large numbers says, in time, the bigger population will pan out.
This is exactly the same as trading when you're trading,
you know what the expectancy is. You're not going to throw out the strategy, just because you got a few wrong.
Let me explain that again,
using a chart.
Okay, so you got yourself a strategy you back-tested your strategy
You know what's expected of that strategy. Remember with the coin toss, you know it's expected return-
50-50. So this strategy you've run it through your back testing and you're confident that you want to start trading this.You've seen...
...the equity curve in the back test. Now any equity curve or any chart will normally have the time on the horizontal axis and the...
...value on the vertical axis. And your strategy expectancy looks something like this.
Think hey, that's a good strategy.
I'm now going to start trading this with my hard-earned dollar, and off the bat you start trading and what happens...
*inaudibles*. You start losing money.
Hang on, this isn't what I was expecting this has got a positive expectancy this strategy should deliver me a good...
return on my investment. In reality,
you don't know if this period here, is in fact, this period here...
...or this could be this period here of the equity curve or indeed, this period here.
So you ditch the strategy...
...or you tweak the strategy, you change it, because it's had this...
...inevitable losing period. Every strategy will have its losing period, and this is the whole premise behind the law of large numbers.
You've got to look at your trading in the big picture, not just about the last trade or the next trade,
but the bigger, bigger picture. Don't get too stressed about the now moment, look at the bigger picture.
Let the strategy play out you've done your back-testing,
you know the expectancy, give faith in that strategy, and don't you stir it out, or tweak it because of the inevitable losing periods.
Okay, so I hope you enjoyed that and indeed, found it useful. Do give me a thumbs up if you did give me a thumbs...
down if you didn't. I'm big enough and bold enough to accept it.
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...forexsignals.com. Until the next time, safe trading speak to you soon!