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# School Project on Probabilities

Discussion in 'Trading' started by Sam Mcgee, Jan 2, 2007.

1. ### Sam Mcgee

My daughter in highschool has to do a math project about probabilities. I told her that a good subject would be how probabilities are used in trading.

Could anyone point to a good web site that she could reference where it shows a simple trading method with probability statistics and how they apply to trading?

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2. ### JimmyJam

Here's a whole slew of free articles on probability in relation various factors which affect successful trading such as money management, risk management and the good 'ol 80/20 rule (where's B1S2, he's gonna luv that one!) from the Trader Mike blogspot.

JJ

Nah tell her to do it on how a casino makes money, more glamorous

Probabilities in trading isn't a easy project. First you have to create a artificial normal distribution. Then you can apply probability techniques that are only estimations. It would be much easier to do one on a game like blackjack where there is a solid structure.

Exactly!

6. ### Batman28

man are u nuts? putting picture of daughter up ??!?? wtf? what are u thinking? what is this?

just wierd..

7. ### JimmyJam

Oh, da heavy hitters are comming out to play!

Here's a thread which gives a good introduction to the concept of a normal (or theoritically even) distribution using a hypothetical data series:
Normal Distribution

... and here's the reality that we experience when we are actually trading and try to make sense of:
MODELS OF DISTRIBUTIONS and finally, why it's impossible to quantify using finite (real) numbers:The Normal Curve

In short, those guys are right, but it's important to figure out why they are right, more so than to just take it at face value.

Because once you have done this exercise, you will understand why trading successfully consistently is such a difficult task.

Here's the whole page:Chapter 5: Normal Distribution

JJ

8. ### Batman28

forget normal dis.. has little relevants to trading.. if it was me i'd tell her to look how bookies price bets on sport/horses to make profit (adjusted so that prices don't equal probabilities) - and how this applies to neutral pricing of options etc..

attached, I've OCR scanned two pages from Financial calculus introduction to derivative pricing - Baxter & Rennie..

"arbitrage pops everywhere"

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9. ### nitro

Imo that is not true.

To the original poster: Look at the way that options prices are set by tree options models (Binomial/Trinomial etc). Imo there is no better example of using probabilities in the market to "correctly" price instruments. Understand the weaknesses in these and then see how Monte Carlo simmulation (grounded in Probability Theory) is used in cases where trees don't work well.

It is great that she is studying prob/stats in high school. Unfortunately, a deep treatment of both requires Calculus (Analysis) and in particular Measure Theory.

Here are some nice lecture notes that you can browse and help her study:

http://www.math.uconn.edu/~bass/lecture.html

nitro

10. ### JimmyJam

Wow, you sure did open a Pandora's box with this one!

Keeping with theme of probability, (because that's what you asked for), I might go with a basic explanation of the concept:

http://en.wikipedia.org/wiki/Classical_definition_of_probability and then I might list different examples of how using probability with money management and different risk:reward levels (risk:reward of 1:1 / 1:2 / 1:3 / 1:4) gives different trading results ... and then analyzing how time (number of trades) allows these different scenarios to play out.

theoretical example:

A trade with a risk:reward level of 1:3 would need to work only 33% of the time to produce a positive result, whereas a trade with a 1:1 risk:reward level would need to work grater than 50% of the time (anywhere from 66% to 75%) to produce a positive result.

By factoring in position sizing you (or she as the case may be) could actually put together a decent money management model for the class.

Regards,

JJ

#10     Jan 2, 2007
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