Since the dawn of time, humans have used pattern recognition to first survive and then thrive. By observing patterns from their environment, like the weather and the animals they hunted, they knew when to plant their seeds and how to make hunting—and themselves—more efficient.
They could pick up on these patterns because they reliably repeat themselves year in, year out. You know what they say about history repeating itself.
Today we still study, recognise and use patterns to live our lives, protect ourselves and look for opportunities. This also applies to looking for opportunities in financial markets. Whether you’re an investor or a trader, we look for things and patterns that happened before and bet on them repeating again. We also look for signs signalling these patterns, just like dark clouds would indicate rain.
This time IS different
Unfortunately, because of this pattern-spotting wiring our ancestors depended on, we also believe the patterns we identify in the markets are the same as all the others we’ve identified before. But they are merely similar, not the same. Even if you correctly predict the direction of the market based on the “sameness” of the pattern you observed, it’s still different from past patterns.
One of the most important things to understand as a trader is that each trade is unique and statistically independent from previous trades. Each trade, no matter how great and confident you feel about it, has a probable outcome. Understanding this concept separates the successful traders from the rest – the successful trader accepts this concept.
It’s human nature to expect history to repeat itself simply because we’ve seen the pattern before, and we expect the same outcome. If we won the last time, we naturally EXPECT to win again. If we lost the last time, we feel anxious about the trade.
But we fail to realise that this time IS actually different. And that this time is also subject to the laws of probabilities. This belief or instinct leads us to take bigger bets than our accounts can handle. Or miss out on a trade.
The risk-free trade
There are many definitions of risk. Most common is ‘the possibility of incurring a loss’. But my favourite definition is this: ‘Risk is the difference between expectation and reality’. Like when you make a trade expecting to make money, with the risk being that you don’t.
A successful trader accepts that anything can happen, from making a loss, to winning or breaking even. So they get what they’re expecting, meaning they’re trading risk ‘free’.
Thinking in probabilities
The solution to this problem, if we can call it that, is adapting your mindset to think in terms of probabilities. For example, if you flip a coin and called it correctly, would you expect to be right again the second time just because you called it the first time? Of course not. Because you understand that the outcome of that flip is random, right? It’s no different with trades. On each individual setup, the outcome is as random as the flip of a coin. Every trade in its simplest form has a 1/3 probability of a win (win, loss, break-even).
At the core of thinking in probabilities, especially in the context of trading financial markets, is taking the view that every outcome is the correct outcome. Even if it’s an outcome we didn’t want when putting on the trade.
If the trade you take has a 99% probability of being a winner and it turns out to be a losing trade, don’t blame the trade. You’re just experiencing the other 1% probability.
Remember the risk-free trade we mentioned earlier? If we change our mindset to expect all three outcomes as possibilities, we wouldn’t have trouble taking the trade again if we lost the last time. Nor would we feel compelled to trade in a size bigger than our accounts can handle.
More importantly, by truly expecting anything to happen, we aren’t susceptible to the emotional extremes that are part of experiencing something we didn’t expect.
In closing, when you’re placing a trade, remember that it’s one out of many trades you will take. And remember that the trade is unique from all the other trades you’ve taken before. Because this time IS different.
Traders share a peculiar characteristic: they’re fiercely competitive, but only with themselves. In practice this means that they see every outcome as an opportunity to learn, and they’re brutally honest about both their failures and successes. This also means that they’re hungry for knowledge. They don’t sleep easy with unanswered questions. And they’re seldom satisfied with just one answer.
Find him on Twitter: @njabulo_goje.