Poker and technical analysis are two disciplines that get a bad rap from the general public. Personally, I’m an avid poker player and an average technician and it bothers me that so many people consider both to be gambling. I think the reason that both poker and technical analysis suffer from the same ill deserved reputation is because they both depend on exploiting statistical probabilities. It seems many people are uncomfortable taking advantage of probabilities. But whether they know it or not, they do it every single day.
That last statement is sure to scare some of the people reading this article. People don’t like probabilities. To most people, saying something is probable means that it’s uncertain and uncertainty is scary; especially when it comes to money.
When it comes to the important stuff like money, people what a sure thing. They want certainty. They want to know that come hell or high water their money will be there when they need it. In short, most people what a safety blanky to snuggle and keep them warm. The problem with this mentality is that absolutely nothing is certain. To quote Voltaire, the 18th century French philosophes:
Doubt is not a pleasant condition, but certainty is absurd.
It’s true that when you think about the world as a place where nothing is concrete and everything is in constant flux, it can be scary. But if you look at the world in absolute terms you’re deluding yourself and you could miss out on some very profitable opportunities.
Take comfort in the knowledge that even mundane daily life is full of probabilities. When you get up in the morning and decide to drive to work there’s a small chance you’ll get in a fatal car wreck; yet you accept the risk, go to work, and earn some money. Even now as I type this article there’s a chance that the roof above me will collapse. Yet I accept the small risk and continue typing. By accepting these small risks in exchange for a greater reward, we all are exploiting probabilities.
How does this all pertain to poker and investing? Take poker for example. Texas Hold’em is all about probabilities. There are 52 cards in a deck with 13 of each suit and 4 of each card. You can use that knowledge to figure out probabilities. For example, if I’m holding the Ace and Queen of diamonds and the first three cards I see are a Jack, Eight, and Two with two diamonds on the board, I’m in pretty good shape with two cards to come. I could possibly win with any Ace, any Queen, or any diamond. My odds of winning could be as good as 62%. There are other factors involved in poker too, but I won’t get into that here. The point is that making money in poker is all about taking the good odds and making your opponent take bad odds.
Technical analysis is like that too. It’s all about trading high probability patterns. If the price of a stock, currency pair, or future hits a certain high point repeatedly and can’t get above it, that point becomes a strong resistance level. Likewise if the price can’t seem to go below a certain point, then a strong support is established. But what happens when one of those lines gets crossed? There’s a high probability that the price will keep going in that direction. Is this certain? No. Is it probable? Yes. So we make the trade.
Patterns can fail. If you read any forums or newsletters on technical analysis, you’ll here about failed patterns constantly. So how do you insulate yourself from this risk? To protect yourself, you need to look for favorable risk to reward ratios.
Basically risk to reward ratios are determined by how much money you’re risking and how much money you stand to gain. For example, I recently placed a Forex trade on GBP/JPY. My analysis showed that once the price broke through a certain level, it was likely to continue. I made a small trade of 10,000 units. My analysis showed that I was risking around $195 but I stood to gain $907. If I were to make 5 identical trades and lose $195 on 4 of them, I still come out ahead because my risk to reward ratio is so favorable. That trade’s a no-brainer!
I read a book once that said that being right 40% of the time in investing makes you a very wealthy person. Yet for some reason, people still think you need to be right all the time to make money investing. For those people, here’s an example where you can be right and still end up losing money.
Let’s say you’re an ultra-conservative person. Stock charts look like a rollercoaster ride to you and you don’t care for those kinds of headaches. So instead, you invest your money in you bank’s CD. After all, those suckers are FDIC insured! What could go wrong? Here’s the problem:
Let’s say you bought that CD at 5.35% for 5 years. The current rate of inflation is forecasted to be around 4.10% next month. So your effective return is 1.25% annually. That’s pretty pathetic by anyone’s standards. Now look what happens if inflation rises to 6% in a couple of years. You’re losing 0.65% annually! Suddenly that CD isn’t looking so good anymore.
In this world, you can’t be certain about anything. But what you can do is exploit probabilities. In order to do that effectively, you have to know your risk to reward ratio. Remember, whether it’s playing poker or investing in financial markets, you don’t have to be right all the time. In fact, you don’t even have to be right most of the time! You just have to have favorable risk to reward ratios.
Once you accept that there are no certainties, you’ll be able to break through the mental block that prevents so many others from achieving success. When you realize that investing is a numbers game you’ll be able to shrug off your losing trades as just another cost of doing business. You’ll be confident that all you have to do is keep trading and the money will come.
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