The confusion over the World Cup final toss was, thankfully, sorted without bad blood — cricket results go with the toss more often than not. While the chance of winning a toss is 50 per cent, some unlucky captains never win their “fair share”.
Tosses are independent events — a coin has no memory of previous tosses. So, it may land heads (or tails) many times in succession. In the very long run, the ratio evens out but it might not for a particular captain. The odds on a stock market trade are roughly the same as a coin toss, since the third outcome (price staying static) is much less likely, compared to a move either way.
But price movements are not independent of prior moves — traders have memories and trends persist for long periods. During a bearish phase, prices are more likely to continue falling. Conversely during a bullish phase, prices are more likely to continue rising.
Losing traders often subscribe to the same fallacy as unlucky cricket captains. They assume that they will win the next one (trade or toss) because of the “law of averages”. This is false — you can make wrong trades persistently, just as you can lose tosses persistently. If you were betting on a coin-toss, the fair return:risk ratio is 1:1. It would be silly to accept a return lower than that since a balanced coin never offers a win:loss ratio of better than 50 per cent (1:1) in the long run. Most traders mess up because they work very hard on trying to generate a higher win:loss ratio rather than trying to generate a higher return:risk ratio. No matter how good your analytical abilities, it is difficult to trade with frequency and knock up win:loss ratios that are much better than 1:1. A stock trader actually should focus on squeezing out a return:risk ratio of better than 1:1 and that is where the smart trader scores.
Successful traders often have win:loss ratios near the average expectations of 50 per cent that you could achieve through a random selection. Some of the most successful traders have win:loss ratios lower than 50 per cent.
In fact, one of the best-known traders used a method, which had a win:loss ratio of no better than 5:95. Nassim Taleb often lost small sums for years in succession because he would take long calls and puts very distant from the money. Once in a while, when the market did see an extraordinary swing, he would make huge returns.
Taleb was working on big, near-perfect markets. In India’s more chaotic conditions, it’s likely his methods could yield even more extraordinary returns. But it takes a strong stomach to employ a strategy, which loses 95 per cent of the time.
The author is a technical and equity analyst
