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when a coin is flipped, it has a 50 percent chance of coming up heads. In order to determine the number of times heads can come up four times in a row, all we have to do is multiply 50 percent four times. |
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The answer is that we have a 6.25 percent probability of heads coming up four times in a row. If we convert 6.25 percent to a fraction, 1/16, we can obtain the ratio. In this instance we would have a 1-in-16 chance of getting heads four times in a row. Now let me ask you a question: What is the possibility of heads coming up the fifth time when we flip the coin? The answer is 50 percent; the reason is that each act of flipping the coin is an independent event! However, the probability of five consecutive heads is calculated by multiplying 50 percent by itself five times to arrive at 3.125 percent. Remember, independent events are those events not affected by a prior event. How many traders after experiencing four consecutive winners are not ready to bet everything on the next trade? |
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This is very interesting and applicable to trading. Many novice traders who have four consecutive winning trades experience euphoria that knows no bounds. Very rarely will novice traders stop to consider the implications of probability theory regarding a series of winning or losing trades. Although a series of winning trades is always great, and beneficial to a trading account, it is the series of losing trades that has the potential to bankrupt the trader. In addition, a series of losing trades is extremely damaging to the trader's emotional, and psychological well-beingenough so that many traders after experiencing a series of losing trades no longer have the desire or the ability to make effective trades. |
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When considering the possibility of how many losing trades a trader may experience, it is helpful to keep in mind that as the number of trades increases, so does the statistical probability of more frequent and longer sequences of either consecutive winners or consecutive losers. For example, numerous flips of the coin will contain many sequences of consecutive heads, and again many sequences of tails. Naturally, the probability of a particular sequence occurring decreases as its independent repetitions increase. Recall, the probability dropped from 6.25 percent for a series of four heads to 3.125 percent for a series of five heads. |
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In general when devising a risk strategy, it is best to assume that the probability exists to experience consecutive losing trades. Remember that the probability of experiencing a series of winning/losing trades depends on the trades being totally independent of the prior trade. However, many traders are trading markets and methodologies that are correlated either pos- |
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