The risk-reward ratio is one of those things every trader and investor acknowledges and talks about.  A third aspect that gets less love is probabilities.  Not only do we want a good risk-reward, we need above average probabilities to place a trade.

Why do most avoid talking about the underlying probabilities?  I have a few guesses
1)  They are rarely clear and difficult to explain
2)  Most folks want easy answers

3)  That is where trading edges lie

Don’t get me wrong, i’m all for keeping an open mind once in a position.  However, one of the hallmarks of underperformance is striking out on trades even though you get the market right.

How do you improve your probabilities?  Make use of your tools:

  • Technical tools
    • Bollinger Bands are just one example of an invaluable tool if you know how to use them.
  • Common Sense/Critical Thinking – Know where and why buyers/sellers show up
    • A stock sells off on earnings or news that doesn’t affect the larger thesis – that’s a situation where investors would step in.
    • It’s not that simple though, what catalysts are coming in the near future?  Is there more risk(uncertainty) on the horizon in the short term?
    • Is there emotion in the market?
  • Follow Options Activity 
    • Big market players making big bets in front month options tend to tip their hand.
    • If you see a stock at or near a buy point with action coming in, odds are increased that your stock will move soon
It takes a lot of refinement to adequately understand and improve probabilities in trading…A ton.  That said, focusing on this third dimension will increase your learning curve over time.
Trade ’em well