Predicting Forex with Probabilities

06/09/2015 9:00 am EST

Focus: FOREX

Acting like one knows where an investment, such as a currency pair, will end up is an easy way for a trader to get his hat handed to him. Good forex traders analyze the markets and speak in terms of probabilities, not sure things, writes Bradley W. Gareiss of Forex.com.

I often hear beginning traders speak as if they know what the markets will do next. In reality, experienced traders usually speak in probabilities and typically have some form of analysis to back up their opinion.

No one can say that a particular currency pair (or other financial instrument) will move to an exact point with absolute certainty. In fact, I feel it is naive to think that anyone can predict the direction of a currency pair with absolute certainty over a given period of time.

Sure, sometimes you could be correct if you boldly predict that a pair will move to X level with absolute certainty. However, there will be other times when the market doesn't go your way. That is why we must deal with probabilities, because no one knows for sure what will happen next in a given currency pair.

The reason we can never know where a currency pair is headed with absolutely certainty is that the markets move based on the will of every market participant.

Let's suppose that someone stated, "the EUR/USD will definitely rise to point X, before falling down to point Y." They are saying that they know exactly what every market participant (or trader) is thinking, how each of these participants plans to act, and how each participant will respond to the actions of every other participant. Needless to say, no one could ever have that information.

However, it isn't uncommon to see bold predictions that definitively state which direction a currency will pair and exactly where the move will begin and end. No one can know these types of moves for certain. 

Even worse, it isn't hard to find predictions that say something like, "buy the USD/JPY at X or you'll be sorry." This baseless claim gives virtually no useful information, because we don't have any idea how long of a trade this would be or where the exits (stop and limit(s)) are.

Without being too harsh, just beware of anyone who claims they know for certain where a currency pair is headed. Of course, everyone is entitled to his or her opinion, but that doesn't mean they know what will happen next.

Even if an insider were to know about an interest-rate change ahead of its release, that doesn't mean they can predict exactly how the market will act. What if the interest rate briefly raises the pair into massive stop-sell orders that actually moves the market down for the day? What if enough market participants felt the rate would move higher, so the pair moves lower?

There are endless scenarios, but it is virtually impossible to predict how every market participant will act within a constantly changing market.

Therefore, we must think in probabilities. No matter how sensational your analysis is, sometimes you will simply be on the wrong side of the market. Whether you are looking at fundamental news announcements, a combination of technical tools, or a simple moving average, what traders are looking for are patterns that put the probabilities in their favor so they will profit in the long run. In other words, they are looking for how the market has reacted in the past to certain conditions and speculating about how likely the market will react in the future to similar conditions.

Regardless of the tools you use to analyze the market, you are still working with probabilities. If you find a system that is profitable over a long period of time, that system is likely putting the probabilities on your side.

These systems come in a variety of shapes and sizes. Some traders (like the famous Turtles) lost far more trades than they won. However, when they won, they usually won big.

Some traders try to win the vast majority of their trades while risking a lot, but gaining little. Of course, there are all sorts of variations and methods besides those two examples.

It is plain to see that it is not necessary to know where the market will go on each individual trade. Instead, it is important to have a system that puts the odds in your favor over a large sample size of trades.

It is pretty easy to see why it makes little sense to get very excited when a trade wins or very upset when a trade loses. As long as the probabilities continue to hold over a long period of time, the individual results for each trade are almost meaningless.

I lose trades all the time and so does every other trader. The key is to manage those losses correctly so that the long-term track record is profitable. The bottom line: thinking of trading in terms of probabilities is a key step to becoming a successful trader.

Bradley W. Gareiss, Contributor, Forex.com

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