Basic Statistics

Trend following is rooted in basic statistical understandings. Take for example the baby boys to baby girls ratio. Consider the following example from research on statistical reasoning. There are two hospitals: in the first one, 120 babies are born every day, in the other, only 12. On average, the ratio of baby boys to baby girls born every day in each hospital is 50/50. However, one day, in one of those hospitals twice as many baby girls were born as baby boys. In which hospital was it more likely to happen? The answer is obvious for a good trader, but as research shows, not so obvious for a lay person: It is much more likely to happen in the small hospital. The reason for this is that technically speaking, the probability of a random deviation of a particular size (from the population mean), decreases with the increase in the sample size.

What does this mean in terms of trading? Take 2 traders that on average win 40% of the time with their winners being 3 times as large as their losers. One has a history of 1000 trades and the other has a history of 10 trades. Who has a better chance in the next 5 trades to have winners only be 10% of their total trades (instead of the typical 40%)? The one with the 10 trade history has the better chance. Why? The more trades in a history, the more probability to adhere closer to the average. The less trades in a history, the more probability to deviate from the average.

How does this help? Think about a friend who gets a stock tip and makes money. He tells everyone. He seems like he really knows his trading. The problem this trader has is that his population of tips is very small. He could just as easily follow the next stock tip given to him and lose it all. One tip means nothing. There is no history. You might as well be playing the lottery or sitting at a craps table.

Trend Following Products

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Michael Covel Trend Following Products
Michael Covel Trend Following Products

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