How many instances of the setup to examine.
In Part 1a and Part 1b of this series of posts, we examined how to determine the likelihood that our exits will be hit. In that particular post, we posited looking at 100 setups, and I said that that was because it made the analysis simpler. Heard from the gallery: “What if I do not want to look at exactly 100 instances?” That is a valid question. To determine the probability of our stop or target being hit first is always a matter of counting how many instances each happens as a fraction of how many instances we examine. This fraction, or the equivalent percentage, is the “probability” that we are seeking.
So let us say that we wanted to examine only the last 50 instances of our setup (instead of 100), because we want to see more recent action only. In that case, because the number of instances that we examine is by definition our sample size, our sample size is 50 . Let us also say that in this case, we hit the stop first 40 times, and the target first 10 time. We would calculate our probabilities as follows.
- ProbabilityStopHitFirst = (number of instances) ÷ (sample size) = 40 ÷ 50 = 0.8 = 80%
- ProbabilityTargetHitFirst = (number of instances) ÷ (sample size) = 10 ÷ 50 = 0.2 = 20%
So it does not really matter how many instances we examine. What matters is what fraction of the time our instances result in specific outcomes.
Caveat: It is all well and good to examine any number of instances, but the number of instances (called the sample size) must be statistically significant, or the analysis is pointless. Looking at the last 3 instances to determine probability is an exercise in mathematical stupidity: there is nothing to be concluded from such a small sample.
In the next post in this series, we shall show how to calculate the Expectation or Expected Value of a potential trade.
In the meantime, if you found this useful, please leave a comment.