Get a trading edge with Probabilistic 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 straightforward judgement and decides that the payoff here for ‘kill you’ is pretty bad -100%. The payoff for food is also there, but it can’t offset the negative. So you walk away cautiously.
The curious thing about this instinct is that it persists today in two forms. The first one is how we treat losses, which also kicks in with how we treat outcomes.
Profits and losses
The first and 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 minds are trying hard to avoid losses.
This was useful many generations ago as it prevented us from getting eaten, but it is of less use in the modern world. However, it still permeates our thinking.
This thinking manifests itself in several 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 effectively put across an argument?
Losses come in many forms, and humans try their best 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. Then again………
Most losses can be contained by forward-thinking or managing the payoff 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 reckless, 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 of what the potential long-term payoff is, and I try to skew that in my favour and repeat. I don’t care about what happens next. I care about what happens over a very long period.
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 think things through rigorously. 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, look at how people react to the information presented in two forms.
Suppose I give facts and judgments on a trading strategy based on years of experience and practice. It will come second, in terms of attention, to advice that says, ‘ Win a fortune, get a second income, quickly & easily with this secret Betfair trading strategy’.
Fundamentally different forces drive instinct and interest. If you 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 con man, just follow your instinct.
When people ask me if something will happen, I typically give a probability back. People hate that.
I once sat in a business meeting where a business plan for the following year was being agreed upon, 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 understood what I was saying.
If you try to tip a sports result, you should also say, ‘There is a 65% chance of XXXX’. That would let the punter know how certain you are and enable them to bet the edge and manage their staking. But of course, absolutely nobody wants that, so people 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, the editors want this. 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. However, I would argue the former produces a better long-term scenario for both parties.
The problem with trading
I’ve spent the last twenty 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 at psychology.
The problem with trading is that it does the exact opposite of what your mind seeks. You have to deal with uncertain outcomes and payoffs that 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 one thing or another when you can’t know the outcome. This leads to mistakes in judgement. People think 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 hard for people to do!
The beginners curse
I once had a conversation with a new trader. To my surprise, he told 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 of experience and accurately reflected the uncertain feeling you get when you trade properly.
There are no easy answers, just set-ups, 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 of strategy, and he seemed to quite like it. Of course it appealed 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 busted 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 okay to be wrong. But there is a caveat: Sometimes, you win, and sometimes, you learn. That’s how it should be. If you lose, examine what went wrong and whether 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 some work, but my best advice is simple.
Avoid the thought processes that most people go through. Once you identify it, you see it everywhere and the flaws it produces. When you see that, you can position yourself in front of flaws. Going back to our bush analogy, it’s like setting a trap. Except 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 who will.
When you start thinking differently, some people won’t understand you, and your judgements and disagreements are common. But in a market, that’s more or less precisely what you want. Nobody would win a penny if everybody thought the same and did the same thing. A difference of opinion is what makes a trading market! Welcome, embrace, and when people disagree, learn to feel reassured about it.
It’s pretty enlightening when you can stop thinking like everybody else. You can see the actual colour of things; it’s not black and white, or ones and zeros. Taking risks in life, on specific judgements and especially when trading, is much more nuanced than that. It’s a judgement on probabilities, with no definitive right or wrong answer.
It was a transformative moment for my trading when I discovered this way of thinking and started adapting my trading to take advantage of these flaws. So that’s why I recommend you explore it fully.