Are you a probability literate person? As a Forex trader, you should be. Understanding the probabilities is one of the most important conditions for success in Forex market and in any other financial trading field. Almost all the FX books we have available on our website mention mass misconceptions that roam the minds of beginning and even professional traders. Fooled by Randomness is a good example of a book that is dedicated entirely to the problem of "probability blindness".
The most interesting thing about probability literacy is that you do not have to be a math guru to judge probabilities correctly. Even some professors and Ph.D.'s may misinterpret random numbers. One just has to understand how probabilities work — what they are and what they are not. It is also important to understand how they relate to the real-world processes and events they describe.
Quite some time ago, we decided to measure the probability literacy among the visitors of this website, who, presumably, are Forex traders or at least are trying to become them. To that end we launched a survey consisting of three questions with two options for an answer each. Later, when we gathered enough responses, we conducted some analysis of the obtained answers to publish the study you can find below.
The results of the suggested polls are quite curious, in our opinion. But first, let us list those questions and the possible answers below.
a. 99.9% chance to win $1,000 (one thousand).
b. 5% chance to win $1,000,000 (one million).
a. 10% chance to lose $3,000.
b. 99.9% chance to lose $200.
a. A strategy that is right 30% of time and is yielding $50 on winning trades and -$10 on losing trades.
b. A strategy that is right 90% of time and is yielding $10 on winning trades and -$40 on losing trades.
The first question was "What would you choose?" And the possible answers were: either a 99.9% chance to win $1,000 (one thousand) or a 5% chance to win $1,000,000 (one million). In currency trading, as well as in any other
P × V
0.999 × $1,000 = $999
0.05 × $1,000,000 = $50,000
Obviously, the second answer is more favorable than the first one as it yields more than 50 times higher expected gain. The point of this test question was to determine how cautious or greedy are the FX traders when the odds are in their favor. Those who chose the first answer rarely follow the "let your profits run" rule and usually prefer to take whatever profit the market is offering them. Those who chose the second answer most probably prefer to keep their profitable positions open for as long as the market conditions remain in their favor.
The second question again was to choose from two possible answers were: either a 99.9% chance to lose $200 or a 10% chance to lose $3,000. Using the formula from the explanation to the first test question, we can calculate the expected values (EV) for both answers. The first
EV = 0.999 × $200 = $199.80
EV = 0.10 × $3,000 = $300
Obviously, the first answer is more favorable as it results in losing less in the long run, even though the probability of loss is rather high. The point here is that the traders who prefer to cut their losses short will choose the first answer as it implies an almost guaranteed but a small loss. At the same time, the market participants that stick to their losing trades in hopes of a reversal will probably choose the second option as it gives them a chance to avoid any loss at all even at the cost of losing a lot if the chances turn against them.
The third question was "What trading strategy would you choose?" and there were two variants to select from: either a strategy that is right 30% of time and is yielding $50 on winning trades and -$10 on losing ones or a strategy that is right 90% of time and is yielding $10 on winning trades and -$40 on losing ones. Let us calculate the expected value for each strategy. The calculations are a bit different here as they are composed of two parts — positive (winning trade) and negative (losing trade). The EV of the first strategy is:
0.3 × $50 — 0.7 × $10 = $15 — $7 = $8
0.9 × $10 — 0.1 × $40 = $9 — $4 = $5
Choosing the first option here would be the most rational choice. This question was meant to detect traders' bias towards strategies that win often but have poor
Based on the answers of the website visitors, the results were the following:
Let's hope that these explanations are clear enough and that they will help you become more
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