STATISTICS
The Longer You Can Stay, The Longer You Can Play
Your Crash Potential
by Wolf von Ronik
Money management alone can increase your chances of trading survival.
Here's a practical explanation.
One of the fundamental realities of successful
trading is the fact that the longer you can stay alive financially in the
market, the greater your chance of monetary gain. The key to improving
your chance of doing so is the implementation of a sound money management
policy. Unfortunately, many neophytes - as well as a few old hands - invest
most of their energies into trying to create the ultimate, foolproof trading
program instead.
A LITTLE PROBABILITY
One of the foundations of probability theory is the concept of an independent
event - an event that occurs regardless of the outcome of the preceding
event. The classic example is flipping a coin. The outcome of each toss
is "independent" of the prior toss.
If events are independent, we can determine the probability that a particular
sequence (or "string") of events will occur by simply multiplying together
the probability of each individual event. For example, the probability
of throwing the given sequence four heads in a row with a balanced coin
is:
0.5 x 0.5 x 0.5 x 0.5 = (0.5)4 = 1/16 = 0.0625
This same methodology can be used for an unbalanced coin; for example,
one that comes up heads 60% of the time and tails 40% of the time. What
is the probability of the sequence of throwing two heads in a row with
this coin? Since the probability of throwing a head is 60% (0.6) and since
the tosses are independent, the answer is:
0.6 x 0.6 = 0.36 = 36%
The probability of the sequence being two tails is:
0.4 x 0.4 = 0.16 = 16%
The probability of the sequence being a tail followed by a head
is:
0.4 x 0.6 = 0.24 = 24%
You get the idea.
...Continued in the July 2001 issue of Technical Analysis of STOCKS
& COMMODITIES
Wolf von Rönik is founder and owner
of Portfolio Analytics, Inc., a financial analysis firm that provides customized
optimal portfolio construction, analysis, and tracking for high-net-worth
individual investors and small businesses. He can be reached at interconltd@juno.com.
Excerpted from an article originally published in the July 2001 issue
of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2001, Technical Analysis, Inc.
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