Trading probabilities: Clear approach to Trade Forex

Forex’s Traders always heard that trading probabilities is one of the most effective strategy that will guarantee sustainable profits and the best way to minimize lost. But many of them don’t know how to do so. This article will explain trading probabilities from engineering background in order to sustain profit and minimize lost, and most of all to make traders accept any lost and never get greedy when won because it will make trader realize that FOREX market are just a simple random movement that no one can guarantee where is the market is heading.

First of all let us prove that the market is a random movement of price where traders try to predicate its next move in systematic way but 90% failed. Many traders use indicators such as moving average, MACD, RSI and stochastic in order to decided either to buy or sell. And many traders who buy or sell based in those indicators lost there trades. why is that?

The answer is very simple and straight forward, because the market is not moving in systematic way. Because if it was, then when you buy based in these indicators you should win as well as when you sell, but since the market is moving in random way you keep losing even when you used these indicators which suppose to help you to win not losing.

Since market moving randomly, the only way to understand it is by applying possibilities or outcomes for its next move and assigned probabilities for those outcomes and see which possibility is more likely to happen next.

When traders treat market as random experiment they will understand it clearly. Any random experiment has an outcome and each outcome has probability of occurrence. If you deal with Forex market as random experiment the outcomes lie in three possibility (up, down, or sideways). Each one of theses outcomes will be assigned probability as following:

Market’s next Moveprobabilities
Up33.3%
Down33.3%
Sideways33.3%
Error0.01%
Total100%
Market outcomes and probabilities

Once siting the outcomes and their probability, traders have to build a hypothesis for each outcome and either accept or reject that hypothesis ( hypothesis mean that assuming the market will move up and then test that assumption with evidence and see if this assumption is still valid or not).

The first hypothesis is market will go up. To test this hypothesis in order to accept or reject it you can ask the following question :

  1. Is the market making higher high and higher lows, if yes that mean the market is in uptrend, and this hypothesis is still accepted.
  2. Does the market pullback to a support and retrace to its original direction which is up with strong candlestick reversal pattern, if the answer is yes then this hypothesis is still valid.
  3. Keep going in asking questions to end up with either accepting this hypothesis or reject it.
  4. Then you divided the probability for this hypothesis which is (33.3%) by the number of the questions to get probability for each question.
  5. In the above example we had two questions and the probability for each question will be (33.3/2) = 16.65%.
  6. Then let us assume that the answer for question one is (yes) it is an uptrend, and the answer for question two is (no) the retrace was not strong.
  7. That means we had (+16.65%) and (-16.65%) because the second question’s answer was no.
  8. That mean the remaining probability for this hypothesis which is uptrend is (33.3%-16.65%)= 16.65%.
  9. Now we have a probability for our first hypothesis which is one of the outcome that market is heading up equal to = 16.65%. Sometimes when all answers are not satisfied that mean we reject this hypothesis and the probability for this outcome equal =0.
  10. Now we can be certain with a probability of 16.65% that market is moving up. But the remaining percent which was substructure earlier can be added to either the down move hypothesis or sideways in order to end up with higher outcome from three which are (up,down or sideways) and see which one has the higher probability and trade it.
  11. Now you can repeat the process form (1 to 10) to end up with the probabilities for down movement and sideways.
  12. Once you preform these processes and come up with all the probability for all three outcomes then you can trade in direction of the outcome that has higher probability using price actions or any other secondary indicators such as (Moving average,MACD,RSI).

Randoms experiment can be varied from tossing a coin to see the outcome if it was head or tail, to more sophisticated experiment such as predicting the Market movement. In my opinion Forex market is a random experiment where a lot of factors contribute to its movement that hidden from the ordinary trader. For traders to understand this market I urge her to go back and study the random experiment in details to come up with a strategy – or update the above explained one – that help her beat the market by making profit consistently and accept lost. I know that will never be hard for Forex traders because they were able to make profit with this giant market but were not able to keep it because they never think about the market as it is moving randomly.

Fundamental Analysis vs. Technical Analysis in Financial Markets

There are two types of analysis people using in the financial market and they are fundamental analysis and technical analysis. In the stock market, the fundamental analysis is different than these analyses used in Forex or commodities market. On the other hand, Technical analysis is the same for all markets. Because of that I am going to start with it and explain what is it and how can it be used.

Technical analysis is a set of tools traders used that built based on historical data to predict the future movement of a security. The most important tool or indicator used in this type of analysis is the price movement which can be recognized by identified the direction of movement if it is going up, down or sideways. Technical analysis tools divided into two types which are primary indicators and secondary indicators.

The primary indicator is price movement and volume. Volume is not recognized in Forex and commodities markets since they are decentralized markets but in the stock market, you can see the volume for each day and week clearly because it is a centralized market. This is what I believe the reason that a lot of traders failed to trade Forex and commodities and have success in trading in the stock market.

When I said primary indicators that means traders cannot go against them. Traders cannot buy when the price is going down and volume increasing with this movement, as well as they cannot short or sell when the price is going up and the volume is going up too. They might think of buying when the price is going down and stop making new lower lows with fading volume as well as they might think of shorting or selling when price stop making new higher highs with decreasing volume. But the actual trade cannot happen until the definition of up/down trend is fulfilled, and that when the price starts making new higher high and new higher low for uptrend where a trader can buy, and price start make new lower low and higher low for downtrend where trade can sell.

The other indicators in technical analysis which called secondary indicators can be used to confirm the primary one, and they are moving average, MACD, RSI, Stochastic and all other indicators that used price in its formula. Traders are allowed to go against these indicators since they are following the price and once trader makes sure that she is almost got the primary indicators in her favor. These indicators mainly used to confirm the direction of the price. Some of these indicators such as MACD and stochastic can be used by smart traders to measure the momentum of the movement and identify if this up movement is just a correction wave or exact wave and also can predict if there is a new up/down trend is about to happen.

Fundamental analysis for the stocks market is different than those for Forex, but the only thing that they share in common is that a stock or Forex pair will go up when demand increase than supply and they will go down when demand is decrease than supply. Since we are not an insider in the financial institutes and banks or stock exchange, we cannot know such things about those markets unless by trying to predict the next move by using indicators that we have in our hand correctly.

For stocks market the fundamental analysis based on the financial statement of the company, cash flow, income statement and/or the earning that company made. Also, it can be sales that the company achieved which can be used as a leading indicator to predict if there will be an increase in the company’s earning or not. Asset and liabilities also are good fundamental analyses that can be used to measure the capability of a company to transform its assets to make a profit. But the only indicator that can be used as main indicators in fundamental analysis is the earning per share (EPR). This indicator is the reason why there is an increase/decrease in demand in any stock. All other financial indicators or ratios need to support this indicator because if they are not, investors and traders alike need to know there is something wrong in this company and they should escape investing in it except for short term traders who only can trade stocks even if the fundamental was bad but only for not more than three months.

Forex market fundamental analysis is different than those used in stock markets. The main indicator in the Forex market is the interest rate. Whenever it goes up the currency will go up and whenever it went down the currency will fall. The interest rate in the Forex market is just like the earning of stock in the stock market. Other indicators used in fundamental analysis in the Forex market such as the unemployment rate, inflation, and debt to GDP. Those indicators can be used as a leading indicator to predict if there will be an increase in the interest rate that will happen by the federal bank or not. The increase/decrease in interest rate can take a while to affect the related currency and it can be year or two, but in the end it still the only indicator that affects the currency market.

Fundamental analysis can be used for investment. For example, if investor sees an opportunity in a company and she is willing to wait for 10 or 15 or maybe 20 years for her investment to be fruitful, then she can just invest in that stock with neglecting the technical analysis and she does not need to bother herself with moving average or price direction because she bet in company not price as I described before. But if she is a trader especially short-term trader, then she needs to think twice before making trade about the direction of the price and how does it react with the nearest moving average as well as other confirmation indicators such as MACD or stochastic. She needs to invest her time in technical analysis and ignore the fundamental analysis. But if she trades for mid to long term, then it’s good for her to combine the two approaches. It will be better for her to understand if the stock she is about to trade belongs to a good company or not, and then she needs to see if it is a good time for her to jump in that stock or should she wait until she sees that the price is start going in uptrend and that movement is confirmed by the other many indicators.