Probability is often needlessly presented as a complicated phenomena and as such a difficult issue to process for traders. When we break the concept down as a process, probability centres on one key and simple aspect; what will probably happen next.
We're often reminded when trading forex, that it's important not to fight, or trade against the trend. We can extend that thought and experiment to not trading against probability.
Now we need to identify what probability actually is (in terms of trading), where and how it's most likely to influence our trading. So let's quickly look at examples of how probability works, in terms of economic events and the effect various announcements may have on our markets.
For example; if the USA's central bank the Fed via the FOMC, decide to raise interest rates (particularly, suddenly and without forward guidance), then the chances are that the value of the dollar will immediately rise, versus its major currency peers.
The dollar will probably rise if the FOMC raise rates unexpectedly by 0.5% and we can take advantage of this probabilistic event. Other examples would include: if the GDP of a country misses, or beats the forecast by some distance, if unemployment figures disappoint, if certain PMIs miss, or beat predictions. We'll probably witness a highly predictable and rapid effect on the forex markets if these data releases miss or beat forecasts. So isolating and using probability, in relation to a high impact calendar news event, is a straightforward exercise, in terms of fundamental analysis.
Now let's turn our attention to how probability can be observed in technical analysis. If, for example, two simple moving averages cross on a lower time frame, perhaps 1hr - 4hr, perhaps a fast moving average (5 day period), crossing a slower one (21 day period), then the probability is that price is moving and diverging from a mean (average) recent level. Therefore we can potentially predict, with a level of certainty/probability, that price will move in a certain direction; long or short. We can extend this visualisation to other technical indicators, for example; the MACD.
We can extend our theory of probability in more depth, will price probably move in a bullish manner above certain levels and a bearish manner below other levels? For example; if price is above R1, then can we confidently predict (in all probability) only long day trades will prosper, and vice versa for S1 and short trades?
Naturally we've kept this explanation simple, to illustrate how the concept of probability in relation to our trading, can work in our favour. Using our examples we could link all three together to deliver a high probability scenario.
For example; after a high impact, economic, calendar news event is released, if it beats forecast, and we see movement on technical indicators on time frames adjusted to day trading, and the price of our forex pair moves towards either S1 or R1, then can we probably predict what price will do next?
We've often discussed our 50:50 random coin toss theory as a phenomena, when trading forex pairs, although it's an impossible calculation to establish, it's worth considering by how much we'd tilt the probabilities in our favour by employing even the most basis analysis as we've just outlined, in order to find ourselves on the right side of the market. Could we be giving ourselves a 50% greater chance of success, if we trade with the daily trend with the news event release and with R1 and S1 in focus? Probably.
