Exactly what does it mean to think in probabilities, and why is it so essential to one's consistent success as a trader? If you take a moment and analyze the last sentence, you will notice that I made consistency a function of probabilities. It sounds like a contradiction: How can someone produce consistent results from an event that has an uncertain probabilistic outcome? To answer this question, all we have to do is look to the gambling industry. Corporations spend vast amounts of money, in the hundreds of millions, if not billions, of dollars, on elaborate hotels to attract people to their casinos.

If you've been to Las Vegas you know exactly what I am talking about. Gaming corporations are just like other corporations, in that they have to justify how they allocate their assets to a board of directors and ultimately to their stockholders. How do you suppose they justify spending vast sums of money on elaborate hotels and casinos, whose primary function is to generate revenue from an event that has a purely random outcome?

Here's an interesting paradox. Casinos make consistent profits day after day and year after year, facilitating an event that has a purely random outcome. At the same time, most traders believe that the outcome of the market's behavior is not random, yet can't seem to produce consistent profits. Shouldn't a consistent, nonrandom outcome produce consistent results, and a random outcome produce random, inconsistent results? What casino owners, experienced gamblers, and the best traders understand that the typical trader finds difficult to grasp is: even that have probable outcomes can produce consistent

results, if you can get the odds in your favor and there is a large enough sample size. The best traders treat trading like a numbers game, similar to the way in which casinos and professional gamblers approach gambling. To illustrate, let's look at the game of blackjack. In blackjack, the casinos have approximately a 4.5-percent edge over the player, based on the rules they require players to adhere to. This means that, over a large enough sample size (number of hands played), the casino will generate net profits of four and a half cents on every dollar wagered on the game. This average of four and a half cents takes into account all the players who walked away big winners (including all winning streaks), all the players who walked away big losers, and everybody in between. At the end of the day, week, month, or year, the casino always ends up with approximately 4.5 percent of the total amount wagered. That 4.5 percent might not sound like a lot, but let's put it in perspective. Suppose a total of $100 million dollars is wagered collectively at all of a casino's blackjack tables over the course of a year. The casino will net $4.5 million. What casino owners and professional gamblers understand about the nature of probabilities is that each individual hand played is statistically independent of every other hand. This means that each individual hand is a unique event, where the outcome is random relative to the last hand played or the next hand played. If you focus on each hand individually, there will be a random, unpredictable distribution between winning and losing hands. But on a collective basis, just the opposite is true. If a large enough number of hands is played, patterns will emerge that produce a consistent, predictable, and statistically reliable outcome.

's what makes thinking in probabilities so difficult. It requires two layers of beliefs that on the surface seem to contradict each other. We'll call the first layer the micro level. At this level, you have to believe in the uncertainty and unpredictability of each individual hand. You know the truth of this uncertainty, because there are always a number of unknown variables affecting the consistency of the deck that each new hand is drawn from. For example, you can't know in advance how any of the other participants will decide to play their hands, since they can either take or decline additional cards. Any variables acting on the consistency of the deck that can't be controlled or known in advance will make the outcome of any particular hand both uncertain and random (statistically independent) in relationship to any other hand. The second layer is the macro level. At this level, you have to believe that the outcome over a series of hands played is relatively certain and predictable. The degree of certainty is based on the fixed or constant variables that are known in advance and specifically designed to give an advantage (edge) to one side or the other.

The constant variables I am referring to are the rules of the game. So, even though you don't or couldn't know in advance (unless you are psychic) the sequence of wins to losses, you can be relatively certain that if enough hands are played, whoever has the edge will end up with more wins than losses. The degree of certainty is a function of how good the edge is. It's the ability to believe in the unpredictability of the game at the micro level and simultaneously believe in the predictability of the game at the macro level that makes the casino and the professional gambler effective and successful at what they do. Their belief in the uniqueness of each hand prevents them from engaging in the pointless endeavor of trying to predict the outcome of each individual hand. They have learned and completely accepted the fact that they don't know what's going to happen next. More important, they don't need to know in order to make money consistently.

Because they don't have to know what's going to happen next, they don't place any special significance, emotional or otherwise, on each individual hand, spin of the wheel, or roll of the dice. In other words, they're not encumbered by unrealistic expectations about what is going to happen, nor are their egos involved in a way that makes them have to be right. As a result, it's easier to stay focused on keeping the odds in their favor and executing flawlessly, which in turn makes them less susceptible to making costly mistakes.

They stay relaxed because they are committed and willing to let the probabilities (their edges) play themselves out, all the while knowing that if their edges are good enough and the sample sizes are big enough, they will come out net winners. The best traders use the same thinking strategy as the casino and professional gambler. Not only does it work to their benefit, but the underlying dynamics supporting the need for such a strategy are exactly the same in trading as they are in gambling. A simple comparison between the two will demonstrate this quite clearly. First, the trader, the gambler, and the casino are all dealing with both known and unknown variables that affect the outcome of each trade or gambling event. In gambling, the known variables are the rules of the game. In trading, the known variables (from each individual trader's perspective) are the results of their market analysis. Market analysis finds behavior patterns in the collective actions of everyone participating in a market. We know that individuals will act the same way under similar situations and circumstances, over and over again, producing observable patterns of behavior. By the same token, groups of individuals interacting with one another, day after day, week after week, also produce behavior patterns that repeat themselves. These collective behavior patterns can be discovered and sub- «pnii<=-nflv identified bv nsinf analvtical tools such as trend lines, moving averages, oscillators, or retracements, just to name a few of the thousands that are available to any trader. Each analytical tool uses a set of criteria to define the boundaries of each behavior pattern identified. The set of criteria and the boundaries identified are the trader's known market variables.

They are to the individual trader what the rules of the game are to the casino and gambler. By this I mean, the trader's analytical tools are the known variables that put the odds of success (the edge) for any given trade in the trader's favor, in the same way that the rules of the game put the odds of success in favor of the casino. Second, we know that in gambling a number of unknown variables act on the outcome of each game. In blackjack, the unknowns are the shuffling of the deck and how the players choose to play their hands. In craps, it's how the dice are thrown. And in roulette, it's the amount of force applied to spin the wheel. All these unknown variables act as forces on the outcome of each individual event, in a way that causes each event to be statistically independent of any other individual event, thereby creating a random distribution between wins and losses. Trading also involves a number of unknown variables that act on the outcome of any particular behavior pattern a trader may identify and use as his edge. In trading, the unknown variables are all other traders who have the potential to come into the market to put on or take off a trade.

Each trade contributes to the market's position at any given moment, which means that each trader, acting on a belief about what is high and what is low, contributes to the collective behavior pattern that is displayed at that moment. If there is a recognizable pattern, and if the variables used to define that pattern conform to a particular trader's definition of an edge, then we can say that the market is offering the trader an opportunity to buy low or sell high, based on the trader's definition. Suppose the trader seizes the opportunity to take advantage of his edge and puts on a trade. What factors will determine whether the market unfolds in the direction of his edge or against it? The answer is: the behavior of other traders!

At the moment he puts a trade on, and for as long as he chooses to stay in that trade, other traders will be participating in that market. They will be acting on their beliefs about what is high and what is low. At any given moment, some percentage of other traders will contribute to an outcome favorable to our traders edge, and the participation of some percentage of traders will negate his edge. There's no way to know in advance how everyone else is going to behave and how their behavior will affect his trade, so the outcome of the trade is uncertain.

The fact is, the outcome of every (legal) trade that anyone decides to make is affected in some way by the subsequent behavior of other traders participating in that market, making the outcome of all trades uncertain. Since all trades have an uncertain outcome, then like gambling, each trade has to be statistically independent of the next trade, the last trade, or any trades in the future, even though the trader may use the same set of known variables to identify his edge for each trade. Furthermore, if the outcome of each individual trade is statistically independent of every other trade, there must also be a random distribution between wins and losses in any given string or set of trades, even though the odds of success for each individual trade may be in the traders favor.

Third, casino owners don't try to predict or know in advance the outcome of each individual event. Aside from the fact that it would be extremely difficult, given all the unknown variables operating in each game, it isn't necessary to create consistent results. Casino operators have learned that all they have to do is keep the odds in their favor and have a large enough sample size of events so that their edges have ample opportunity to work.