IP Lesson 6 Flashcards
BIG IDEA : Describe the concept of trading an edge.
Trading an edge means having a positive profit expectation based upon a mathematical probability model, and then aligning my real world behaviour and trading activity as closely as possible to the strategy derived from the model.
Why is trading an edge vital to your success as a trader?
Because it is the mathematical edge which ensures profit over time.
Why is it important to understand the concept of trading an edge itself?
Because it allows me to realistically align my expectations towards profitable trading.
How is basic probability calculated?
The number of ways an event can occur, divided by the number of possible outcomes.
In the example of a coin flip, the probability of flipping a head is 1 ( it can only occur one way ) and the possible outcomes are 2 ( heads or tails ) . In this case, what is the probability of flipping a head?
1/2 = 0.5, 50%
In a simple 50/50 event, what is the profit expectation if the same profit or loss is applied to both probabilities?
( $1 x 0.5 ) + ( -$1 x 0.5 ) = ?
0
What is the profit expectation when a 50/50 event has a $1 upside, but only a $0.9 downside?
( $1 x 0.5 ) + ( -$0.9 x 0.5 ) = $0.05
What are the 4 factors affecting profit expectation?
Win rate, loss rate, Profit on wins, cost on losses.
Why is it that sticking to a strategy, even one that is sure to make money, can be a challenge for traders?
Because the brain needs training to think in terms of probability.
In general, do people favour or aver risk when considering gains?
Risk averse.
In general, do people favour or aver risk when it comes to losses?
They favour risk.
How should one deal with losing streaks which occur after one has a confirmed profit expectation, and strict adherence to the rules?
Understand that only over the long term can the system generate consistent profit.
What is the only way to ensure the value of your edge?
To play it consistently over time.
What does the law of large numbers state? ( in regard to trading )
The higher the number of repetitions, the closer to profit expectancy.
What characterizes the beginning samples of a probability model?
They are totally sporadic.
When should a probability model be expected to settle into it’s expected outcome?
Over hundreds of repetitions.
With regard to the rules casinos follow for their own business model : How do they handle not knowing if they will make money on a given spin?
They don’t need to know.
With regard to the rules casinos follow for their own business model : Why do they not need to know if they will make money on a given spin?
They make money from positive profit expectancy.
With regard to the rules casinos follow for their own business model : How do they maintain positive profit expectation?
Have strict rules and never break them.
With regard to the rules casinos follow for their own business model : How do they handle losing streaks?
Staying calm and sticking to the rules!
With regard to the rules casinos follow for their own business model : How do they move towards their “expected outcome” & positive profit expectation?
Ensuring they can participate in as many games as possible.
In regard to calculating profit expectations for trading, what does a 1:1 strategy refer to?
Risking 1% to make 1%
How to enter a 1:1 trade?
Set stop loss and profit target equal distances apart.
Once a 1:1 order is live, what are the two options the market can choose?
Move and trigger either the stop or the target.
When should you trade strategies with a reward risk ratio of less than 1:1?
NEVER.
What is the point of 1:1 ratios in trading strategies?
They are the baseline from which to develop a strategy.
What does a 2:1 strategy mean?
Risking 1% to make 2%
How can a 2:1 strategy be most easily achieved?
Placing the profit target 2x farther than the stop loss.
Your 2:1 strategy places your stop loss 50 pips from entry, where is your profit target in pips?
100 away.
What is the net effect of placing the profit target twice as far from entry as the stop loss?
Price must move twice as far to win
When price has to move significantly farther to win, than to trigger the stop, what effect will this have on your strike rate?
I will mean the strike rate decreases, because price has to move farther.
What will be the effect of having your profit target significantly farther away than your stop loss on profit?
The wins will create more profit.
What is the basic characteristic of High Strike Rate models ( HSR ) ?
They win more often than they lose.
What is characteristic of HSR models as compared with HRR models relating to entry?
The entry criteria is more detailed.
How do HSR models usually compare with HRR in terms of confirmation methods?
The use of multiple time frames.
What is the basic characteristic of HRR models?
They win BIG but not necessarily very often.
Compared with HSR models, what is characteristic of HRR models entry points?
There is less emphasis on specific entry points.
What is different about HRR models regarding trade management, when compared with HSR models?
Great attention to trade management ( trailing stops & targets )
Most swing trading strategies follow which of the two basic trading models?
HRR traded on the daily chart
What should be understood about trading HRR models with regard to time in profit / drawdown?
They will tend to lose more often than not.
What is necessary for a trader using HRR methods, with regard to the tendency of these models to lose more often than not?
Greater self-management must be emphasized.
BIG IDEA : Ingredients of trading an edge, what are they?
The ability to calculate probability AND profit expectancy,
understanding the law of large numbers.
When creating a strategy based upon technical analysis, what formula / statement is necessary to guide trading activity?
a pure IF / THEN / AND statement.
With regard to your IF/THEN/AND statement, what does IF refer to?
If criteria a, b, c ( for example ) are true, THEN….
With regard to your IF/THEN/AND statement, what does THEN refer to?
It is the prescribed response to the IF statement,
THEN, take actions 1,2,3.
With regard to your IF/THEN/AND statement, what does AND refer to?
To the management actions which follow trade entry.
AND manage trade with actions x,y,z.
How do HSR models usually compare with HRR in terms of confirmation methods?
The use of multiple time frames.
What is the basic characteristic of HRR models?
They win BIG but not necessarily very often.
With regard to your IF/THEN/AND statement, what does THEN refer to?
It is the prescribed response to the IF statement,
THEN, take actions 1,2,3.
With regard to your IF/THEN/AND statement, what does IF refer to?
If criteria a, b, c ( for example ) are true, THEN….
Compared with HSR models, what is characteristic of HRR models entry points?
There is less emphasis on specific entry points.
When creating a strategy based upon technical analysis, what formula / statement is necessary to guide trading activity?
a pure IF / THEN / AND statement.
BIG IDEA : Ingredients of trading an edge, what are they?
The ability to calculate probability AND profit expectancy,
understanding the law of large numbers.
What is necessary for a trader using HRR methods, with regard to the tendency of these models to lose more often than not?
Greater self-management must be emphasized.
What should be understood about trading HRR models with regard to time in profit / drawdown?
They will tend to lose more often than not.
Most swing trading strategies follow which of the two basic trading models?
HRR traded on the daily chart
What is different about HRR models regarding trade management, when compared with HSR models?
Great attention to trade management ( trailing stops & targets )
With regard to your IF/THEN/AND statement, what does AND refer to?
To the management actions which follow trade entry.
BIG IDEA : With regard to “trading above the average”, what is the basic premise?
That because currencies tend to be trending in nature, they will generally maintain a given direction. This trending can be measured with moving averages, in particular, the 50 day MA.
When “trading above the average” what kind of positions will you take in the market?
Long positions.
Why do long positions in “trading above the average” provide and edge?
Because of the statistical tendency of an uptrend to continue, and carry the the long positions to their targets.
What can be inferred when a pair is trading above it’s 50 MA?
That an uptrend has formed.
When a given pair is trading below it’s 50 MA, what can be inferred?
That a downtrend has formed.
With regard to “trading below the average”, what kind of positions should be taken when a pair is trading below it’s 50 MA?
Short positions.
BIG IDEA : Describe the basic premise of “Trading the runs”.
When a clear uptrend is forming, I can trade with an edge by buying on the pullbacks when price pulls back, and then initiates the next run.
What will be the consequence of other traders seeing a pullback during an uptrend?
They will also stack their orders to catch the next run up, and boost my hit rating.
BIG IDEA : Describe the basic premise of trading support and resistance.
When price finds any form of support or resistance, I can trade with an edge in the direction of the bounce. This is because if I can identify support and resistance, so can everyone else, which will cause orders to stack in favour of the bounce. ( any examples are sufficient; fibonacci, MA, horizontal lines, trend lines )
With regard to trading support and resistance, which forms of support or resistance are valid criteria?
All forms which other traders can see & trade.
With regard to changing your trading routine, what is the main consideration?
The number one priority in all trading is to remain as consistent as possible.
When changing your trading routine, although consistency across all activities is the goal, sometimes a change is required. In which case, how can you time this effectively?
I only ever change my routine AFTER a profitable run.
With regard to changing your trading routine, how should you time the change with regard to when NEVER to change?
Never change during a downturn.
If you need to take a break for a week or more, only do so after what has occurred?
Only after the market has had a significant run.
If you have successfully timed the market running ( taking 3 steps forwards ) in order to book a week or more off, when should you re-enter?
By monitoring to see when my strategy has taken 2 steps back, and re-entering.
What do you need to do during a break from trading activity in order to time your re-entry?
Maintain a chart of my strategy’s hypothetical performance.
Why must you maintain a hypothetical chart of your strategy’s performance during breaks / time off?
In order to maintain the integrity of my probability model.
If you need to switch out a pair, when should you switch a pair out?
When it has been profitable.
When you need to switch a new pair in, when should you bring the new pair in?
When it has been on a losing streak.
What is the “holy grail” of understanding probability and profitability in trading?
Understanding random distribution.
What fundamental concept related to probability is often the biggest challenge to amateur traders in order to become profitable?
Understanding random distribution.
What is the key to being present and ready for winning streaks, with regard to probability?
Overcoming my reaction to losing streaks.
What is the only area in successful trading in which luck plays a role?
The number of times it takes for an edge to play out
could be 10-10,000
What, with regard to probability and human instinct is a key challenge for you to overcome?
The attempt to predict when winning trades SHOULD occur.
It’s not the point!
What can happen during the initial period of a trading career, while the probability model gathers potential?
The account equity may simply range sideways.
What happens once a new account / trader’s probability model has had a chance to play out it’s edge over time?
THE BIG MONEY WILL COME!
Why is it important to realize that even with a 50/50 hit rate, a trader will encounter some losing streaks?
Because I must maintain my cool and keep to my system during such periods.
Why is it vital to understand that no matter how good my strategies are, I may encounter strings of losses?
Because the way I deal with such losses is what determines my success as a trader.
Why is it important to “have faith” and keep trading consistently during the “run up” period of a new trading career or account?
Because the run-up period is essential for the probability model to “push” the system into profit.
What happens to the probability of a winning streak during periods of drawdown and ranging?
The winning streak becomes exponentially more likely.
What, in terms of probability, causes an account to generate profit and winning streaks after periods of drawdown?
The very act of trading straight through the ranging / drawdown with military grade accuracy and consistency.
When is the best time to enter a strategy?
When it has been performing badly.
Why is the best time to enter a strategy during periods when it has been performing badly?
Because it is therefore due for an upswing!
What happens if a strategy you want to enter has been performing well?
It should be left to settle into drawdown before I enter.
What is the foundational skill of understanding and building models that will effectively mitigate risk and generate profit?
The ability to calculate probability.
BIG IDEA : How does an edge produce profit over time?
An edge is simply a calculation of probabilities which proves that with a large enough sample, profit will be produced. This is a positive profit expectancy. The edge therefore produces profit when the rules are applied consistently and the sample size “pushes” the probabilities into profit.
What does it mean about the viability of a probability model / trading strategy when it encounters a string of losses?
Nothing. Strings of losses are a normal result of random distribution.
BIG IDEA : What is basic probability and how does it serve as a principle of successful trading?
Basic probability is the idea that while a certain event may be likely, it is not guaranteed. The likelihood causes trends to develop over large samples of numbers or trials, and tend to define likelihoods more and more precisely as the sample pool gets larger. The ability to calculate probability of a random event is the foundational skill in order to understand the models that will mitigate risk and create profit.
BIG IDEA : How do the elements of probability and random distribution interact to formulate successful trading strategies?
The element of probability essentially requires and ensures that over a large enough sample, certain trends will be evident, whereas, random distribution means that the actual presentation of the individual events can appear totally chaotic and possibly even unrelated to the likelihood indicated by the probability.
BIG IDEA : How are probabilities calculated, in order produce a system with rules that create an edge?
The basic method is by setting stop loss and profit targets at specific distances from given entry points in the market, the differential between the profit target and stop loss determine the relative likelihood of a “win” or a “loss”
BIG IDEA : How do the settings of the system generate High strike rate or High reward risk models?
If the profit target is set very far from the entry, price has lots of room to move before getting triggered out, and so can generate higher profits, but it also carries the risk that the price may move conversely and get stopped out at a loss, which lowers the strike rating relatively speaking. High strike rating models will “target” out of a trade relatively early for a small profit, but the same proximity that increases my chances of a win, reduce the amount of profit that can be made per trade.
BIG IDEA : What aspect of our human nature must be considered and well regulated in order to trade effectively?
Recognizing that untrained human tendencies run counter to the behaviors that produce actual, mathematical advantages. Realizing this means that I can train myself and my mind to trade an edge, rather than trying to win every trade.
