Lecture five probabilities. So how did you do on the test? For those of you who guess that it must be a winner, your thinking reflects something called gamblers fallacy. And this is one of the biggest factors that impacts a traders account balance. a gambler, or amateur trader thinks that since they've had a run of losing trades, the next trade must be a winner. But this is not the case.

The bottom line is that no one knows the precise outcome of any trade. It could be a winner, or loser. What we do know however, is over a series of trades, the overall outcome will be profitable if our trading system has a positive expectancy And we'll cover this further in the course. What this means is that you don't simply bet the house on the fifth trade, thinking that it must be a winner. Because there was still a chance, in this example a 20% chance that it could lose, since each trade had a 20% chance of losing. This relates to the principle of probabilities, something the vast majority of the population simply doesn't fully understand.

If you are to prosper in the field of trading, then you must get to grips with probability. And if you master probabilities, and begin to think, and trade in this way, you will manage your trade size and not risk too much on one single trade. Because you know that there is no certainty on the outcome of any single trade. This is key with money management for our long term survival as a trader So, when trading, always think in terms of probabilities, and one question I asked myself is, what is the chance that price is likely to rise or fall from this level. And here's the definition of probabilities. So probability is the measure of the likelihood that an event will occur.

In essence, probability is the chance of something happening, and not a guarantee that it will happen. So in this instance, a professional trader would not increase their trade size, thinking that it must be a winner, because there's still a 20% chance that it could lose. Actually, the probability is not changed, just because you've had a string of four previous losers. Remember that your trade results are based on a series of trades and not a single trade. Each single trade is independent with its own chance of occurring. I agree that there is less chance of having five losing trades in a row.

But there is still a random chance that it may happen. And in the world of probabilities, you will run out of money. Long before you can consistently prove that you can predict the outcome of the next trade. The only way that you will see the benefits of your trading system is over a large series of trades. This may seem confusing, so let's get into probabilities and start with something something simple, like the coin toss to illustrate my point. So the coin toss, one toss, what is the chance of actually getting ahead?

Yeah, that's quite simple. There's one outcome out of two permutations. So one out of two is either nought point five or some people say 50. percent. So let's move on to two coins being tossed. What's the chance of getting an equal number of heads and tails? Well, there again is actually four permutations.

And two of these outcomes gives us one head and one tail. So it's still equal at 50%. So if you were trading on the chance of getting one head and one tail, then the odds would still be 50%. And this is where a trader gets confused. They think that their win rate means that they can trade at a level of risk way too high to take account of the chances of a losing streak occurring. In this example, if the head head or tail tail came up, and you have risked half your account on each toss of a coin, your your account your trading account would actually be wiped out.

Now, let's consider the situation where we have 10 coins being tossed. In this example, most people would still think that the chance of getting five heads and five tails would be 50%. But actually, it's not. It's actually slightly under 25%, because there were 252 outcomes from a total number of permutations of 1024. And as you can see, this is gamblers fallacy fallacy, which is caused by a lack of appreciation of probabilities. And this phenomenon is known as the law of small numbers.

Were quite simply your sample size. The number of examples taken here, the number of coin tosses are simply too small to form an accurate prediction of the long term outcome. So what does that mean? Your trading? Well, in order to explain what this means for your trading, let's go back to the coin toss. If we want the probabilities to balance out so that you get an equal number of heads and tails 10 coin tosses are simply not enough as we saw earlier.

To be absolutely certain, you would need to flip the coin an infinite number of times for the probabilities to more closely represent the chances that you would expect and in this case, you expect in 5050. For a trade, you need to have trade tested your trading system a very large number of times in order to accurately predict the outcome of your trades. Like a game in the coin toss, if you base your trade size, in the fact that the chance is 50% you would never have got to 10 trades because you would have blown all your money. This phenomenon Known as the law of large numbers, and this is what you need to consider. And you need to use to see the benefits of your trading system play out over time. So, if we go back to your trading system, you will need to trade at a size that enables you to take the wins the losses, the losing streaks, which in trading we call draw downs over the long term, so that the Lord's law of large numbers begin to work for you.

And you see your trading system play out. If you trade too big, even though you may have a profitable system, you will be wiped out due to this. In the next lecture, we will look at something quite closely linked to this called the probability of Ruin and see what does this mean for you as a professional trader