Author:Game
Compiled by: TechFlow
Probabilistic thinking in trading
Trading, at its core, is about making decisions amid uncertainty. Just like in a poker game, you’re making bets without complete information, which is why many successful traders tend to have a poker background or are well versed in game theory. Both teach us how to think strategically, assess probabilities, and effectively manage risk. By adopting a probabilistic mindset, you shift your focus from predicting outcomes to managing risk based on possible scenarios. As Annie Duke says in Thinking About Bets, “When you’re thinking about betting, you’re thinking about the future as a set of possibilities rather than a single, predetermined outcome.”
Every trade is a bet
Each trade is a calculated bet, not a foregone conclusion. To be successful in trading, you need to think in terms of probabilities. Rather than focusing on the outcome of a single trade, think of it as one of many possible outcomes. This way of thinking helps you avoid emotional reactions to losses or gains, because you know that your strategy's edge will manifest itself over multiple trades. Nassim Taleb reminds us in Fooled by Randomness: "We often think the world is more predictable than it is and that we understand more than we actually do."
Example
Let's say you've spotted a promising trading opportunity in a low-volume altcoin with strong technical signals pointing to a breakout. However, you also realize that there is risk due to low liquidity. By viewing this trade as a probabilistic bet, you can conservatively size your position, thereby ensuring that the trade is in line with the probabilities and minimizing the impact of potential losses.
Think in probabilities
Understanding probability theory is key to adopting probabilistic thinking. It’s about estimating the likelihood of various outcomes and recognizing that no single trade is predictable, but that patterns emerge over time. As Peter L. Bernstein says in Against the Gods: The Extraordinary Story of Risk: “The essence of risk management is to maximize the areas over which we have some control over outcomes, while minimizing the areas over which we have no control at all.”
Example
Imagine you are trading a basket of currency pairs based on a strategy that has a historical win rate of 55%. You know that on any given trade, the outcome is uncertain, like flipping a weighted coin. However, because your strategy has a statistical edge, your focus is not on any single trade, but on consistently executing that strategy over a large number of trades. Over time, a 55% win rate should translate into profits, even if there are losses along the way. The key is to trust the process and let the law of large numbers work for you.
Embrace Bayesian thinking
An important component of probabilistic thinking is Bayesian reasoning, which involves updating your beliefs as new information comes in. In trading, this means continually adjusting expectations based on market conditions and new data. Keynes once said, "When the facts change, I change my mind. Do you, sir?"
Example
Let’s say you see a breakout pattern in a major cryptocurrency and estimate the probability of an up move to 70%. Then, unexpected macro news comes out. You quickly reassess the situation, lower your probability to 50%, and decide to take some profits. This constant adjustment embodies the essence of Bayesian thinking, where you continually refine your probabilities as new data emerges.
Fat-Tailed Risk and Asymmetry
In trading, you must realize that not all risks are equal. Markets often exhibit fat-tailed distributions, with extreme events occurring more frequently than you might expect. Understanding this can help you prepare for unusual events that could significantly impact your portfolio. Nassim Nicholas Taleb warns us in The Black Swan: “The inability to predict extraordinary events means the inability to predict the unfolding of history itself.”
Example
The crypto market is full of such cases, and FTX is a well-known example. Initial concerns about the company's balance sheet quickly evolved into a full-blown liquidity crisis, wiping out billions of dollars in market value almost overnight. This incident highlighted the fat-tail risks inherent in the crypto market, where credit and leverage can escalate a single point of failure into widespread contagion, triggering extreme price volatility across the entire asset class.
Dealing with luck and uncertainty
Luck plays a big role in trading, and while your skills are essential, it is equally important to acknowledge the influence of randomness. By recognizing the role of luck, you can avoid overconfidence and stay disciplined. As Daniel Kahneman mentioned in Thinking, Fast and Slow: "We tend to overestimate our understanding of the world and underestimate the role of chance in events."
Example
Suppose you invested in a DeFi token and it unexpectedly doubled in value due to a regulatory announcement. In this case, you should not increase your investment in similar high-risk assets, but be aware of the impact of luck, remain cautious, and focus on trades where you can better assess the probability.
Avoid the results trap
It’s easy to fall into the trap of “result-ism” by judging your decisions solely on the results. This cognitive bias causes us to overlook the importance of the decision-making process. To avoid this, focus on the quality of the decision-making process rather than the results of individual trades. As Annie Duke emphasizes in one of my favorite books, Thinking Bets: “The quality of our lives is the sum of the quality of our decisions and the luck of our luck.”
Example
You may have profited from high-risk leveraged trades during a local market rally. While it’s tempting to attribute your success to your trading skills, stop and reflect. Through process-oriented review, you may find that this result was more the result of luck than the success of your strategy. Realizing this can help you avoid repeating risky behaviors due to lucky outcomes.
Integrated thinking
By focusing on probabilities rather than certainties, you can make smarter decisions, manage risk effectively, and remain disciplined regardless of the outcome.
“The future is uncertain. Therefore, decisions cannot be made with perfect confidence. But they can be made with courage.” - Peter L. Bernstein
