On Randomness and Streaks

One of my favorite books is Fooled by Randomness by Nicholas Taleb

http://www.amazon.com/gp/product/158...books&v=glance

I’d suggest that you purchase it and read it cover to cover several times. The major theme of the book is that people totally fail to understand randomness – even logical, educated people. In fact, sometimes logical, educated people can be fooled even more than the non-logical, and uneducated.

For example, last week in an article by Chuck Branscomb, you learned that good traders learn to tolerate long losing streaks, including making 12 losses in a row. We got several comments on that one.

Here is one of them:

You say that a winner still knows that he's a winner even after an expected 12 losses in a row. Who in his/her right mind would "expect" 12 losses in a row?

If a system is designed to win 50% of the time, the chances are only 2 in 10,000 of getting such a result if the system is performing as expected.

Even if the system is designed to win only one out of ten (and presumably make more than enough on the one win to make up for the nine losses), the probability of 12 losses in a row is still less than 50/50 at only 28%. Getting a result like 12 losses in a row would more than likely mean that the system is not working as intended.

I understand the intent of your statement, but show me a person who "knows" that he/she is a winner with a system that loses 12 in a row, and I would like to see that system ... so that I can take the other side of the trades.

My guess is that the author of this letter is very intelligent and understands quite a bit about probability. For example, he was able to illustrate that the odds of 12 losses in a row with a 50% system are only 2 in 10,000. He’s a little off — it’s actually 0.000244.

However, his calculations were based upon making 12 losses in a row in 12 trades with a 50% system. What if you make 100 trades each year? Or what if you are a short-term trader and make 1000 trades each year? Then the chances of a long losing streak are quite large.

For example, I did 20,000 Monte Carlo simulations of 100 trades with systems that are 25% correct; one that is 50% correct, and one that is 75% correct just to see what the losing streaks might be. What I found is shown in the table below:

1.)The first column is the win percentage of the system.
2.)The second column shows the length of the losing streak that will occur100%of the time in this system. That is, you are guaranteed of having a losing streak that long.

3,)The third column shows the average losing streak for that winning percentage. You have a 50% probability of getting a losing streak this long.

4).The fourth column shows a 10% probability losing streak. Losing streaks will happen this long 10% of the time if you make 100 trades each year.

5.)The next to last column shows a 1% probability losing steak. In other words losing streaks this long will happen 1% of the time if you make 100 trades each year.
6.)And the last column shows the maximum losing streak in 20,000 simulations of 100 trades.
Losing Streaks As A Function of Winning Percentage of Your System

See Chart Attachment

Notice that with a 50% system, you are almost guaranteed to have five losses in a row in 100 trades and you’ll probably get six losses in a row. If you simply calculated the probability of getting six losses in a row, you’d say it’s unlikely because the probability is 0.0156. You’d conclude that its nearly impossible.

But it’s not impossible in 100 trades. In fact, it’s almost certain.

In our simulation, we also found that you have a 10% chance of nine losses in a row and a 1% chance of 12 losses in a row. One percent is unlikely, but not impossible. And just when you decide it’s impossible, it would probably happen for you.

I don’t have a simulator that will easily do 20,000 simulations of 1,000 trades, which is still quite likely for a short term trader to make in a year. I will easily have over 1,000 trades this year and I’m not a day trader. Many of my clients will easily have 1,000 trades each year. I’m right on about 45% of my trades and I probably have a losing streak as big as 15-20 losses in a row this year. Some of my students (who are superb traders) frequently report losing streaks as long as 20 in a row.

Most long-term trend following systems are not right 50% of the time. They are more likely to be right 30-45% of the time. Thus, the probability of having 12 losses is a row in 100 trades is no longer just a possibility – it’s a distinct probability.

So what does this all mean for you?

It simply illustrates the point that the average person does not understand randomness, even the average highly intelligent person.

Second, it says that long losing streaks are quite possible. Most people who insist on being right will typically give up their system, thinking it is no good. In reality, the system is doing what you probably should expect.

And, lastly it shows the critical importance of position sizing. If you risk 1% on each trade, then after 12 straight losses you’d probably be down about 10% (i.e., you’d be down less than 12% because you’d only be risking 1% of what’s left after each loss).

Your next trade might be a 20R winner and you’d be up — even after 20 losses in a row.

Don't worry, only 2 out of every 100 traders will pick up on this information, the other 98 will be paying for your winning trades the rest of the year