Imagine tossing a coin and trying to predict which side it lands on every time. Every time you throw the coin, it has a 50% chance that it will land on heads, and a 50% chance it will land on tails. Supposing it lands on heads 10 times in a row. Do you think the odds are stacked in your favour by choosing tails and it is more likely to land on tails this time?
The answer is NO! it has exactly the same 50-50 chance that it will land on either side. The only thing you can be sure of is that it has to land. Every time that coin is tossed, the result is completely independent of the last. Even if the coin landed on heads 50 times in row, that doesn’t mean it’s any more likely to land on tails next time, it still has the same 50-50 chance of landing on either side each and every time it is tossed up into the air.
Over the years, many people have been fooled by the theory that it has to land on the side they choose eventually. There are various strategies out there, such as the Martingale strategy, which encourages you to double down after every loss, with the theory that eventually your choice will land in, recovering all losses and putting you into profit. If you had an unlimited bankroll, then maybe eventually this could happen, the problem is that most people do not have an unlimited bank balance to keep betting, and more often than not, find themselves busting out before their selection comes up. The Martingale strategy is something that you should avoid like the plague.
Whenever it comes to trading, the options available are similar to that of the coin. The prices can go up, they can go down, or they can flat-line (money is matched but the price stays the same). Suffice to say, there are various pieces of information available to help us make our decision on which way they will go. Some of it is more reliable than others. There are also a variety of people on the exchange, whether they are other traders, just plain punters, market manipulators, and a whole lot more. At the end of the day, everyone is there attempting to make money. When it comes down to clicking that button to enter the market, in essence all we are really doing is paying to have a look to see if our prediction based on the information we used was right.
Keeping it simple for now, the odds have different increments on the ladder, but for arguments sake, let’s assume for now that they all hold equal value i.e. you win the same amount at each increment. Similar to the coin, if you were to predict correctly 100% on which way they would move, then congratulations, you’ll be rich in no time at all! That’s simply not the case with trading, if it were that easy, everyone would be doing it. If however, you predicted correctly 50% of the time, the other 50% of the time you were wrong, then in “theory” as long as all the profits and losses were for the same amount every time then you would expect to break-even. Sadly it doesn’t work like that, since exchanges charge a commission on all winnings. Using this same example, you win half of your predictions, you lose the other half, assuming same amounts, once the commission from your winning trades is taken then you will actually be in a losing situation (show below)
Win 50 times @ £1 each = £50 profit
Lose 50 times @ £1 each = £50 loss
Commission on winnings at 5% = (£50 profit / 100) x 5% = £2.50
£50 profit – £2.50 commission = £47.50
Final profit £47.50 – £50 loss = -£2.50
Now let’s look at the same example, after you have spent some time developing your skill-set to a 60% strike rate.
Win 60 times @ £1 each = £60 profit
Lose 40 times @ £1 each = £40 loss
Commission on winnings at 5% = (£60 profit / 100) x 5% = £3.00
£60 profit – £3.00 commission = £57.00
Final profit = £57.00 – £40 loss = £17.00
Obviously, there’s a little more to it than just that, strike rate plays a part, as does trading style and odds increments. Some traders prefer scalping, where they are using high stakes for low profits and have a smaller margin for error. Others prefer swing trading, using lower stakes for a higher level of profit. The above is merely just a very simple example to help you get you thinking. Of course there are also ways in which you can have a low strike rate in trading but still finish in profit.