I’m looking to refine my game. I need to start filtering my trades by risk/reward and probability. I have no idea how to do this. Any advice? Any reading recommendations?
I know my stop and my target but both numbers are pulled out of my ass. I read about successful traders and their “high probability” trades and I’m curious how they figure the probability.
Your overall probability is your long term trade win ratio. Per trade probability is contextual and will require in depth analysis, you'll have to develop that for yourself since it will rely on your trading patterns.
What you need to do is backtest your strategies to see if it is a positive or negative expectation. Use the expectation formula. That is how you determine your edge. Each trade is different and even the best setups can and will fail. Add risk management to minimize the chances of blowing up your account and losing all your monies. Risk no more than 2% per trade. Your risk and reward per trade, on average can be calculated when you calculate for positive expectation. How much is your average gain, average loss, win percentage, loss percentage? If your trading system has a negative expectation, do not trade that trading system because it is a guaranteed loser. Only when you have a positive expectation, will you have an edge and should be trading. Otherwise, you will just be gambling.
My main style of trading is discretionary based on fundamentals. I use TA for entry and sometimes exit. Be a discretionary trader its hard to back test markets I know the future of (or past future…).
The calculation of risk/reward and probabilities when talking about the underlying instrument is always going to have huge error margins. Using options to calculate risk/reward and probabilities is more straightforward. Although using options still have error margins in the calculations because of assumptions about market movements, such as price change distributions being normally distributed. One example, see attached.