STATISTICS

The Longer You Can Stay, The Longer You Can Play

by Wolf von Ronik

Money management alone can increase your chances of trading survival. Here's a practical explanation.

One of the fundamental realities of successful trading is the fact that the longer you can stay alive financially in the market, the greater your chance of monetary gain. The key to improving your chance of doing so is the implementation of a sound money management policy. Unfortunately, many neophytes - as well as a few old hands - invest most of their energies into trying to create the ultimate, foolproof trading program instead.

A LITTLE PROBABILITY

One of the foundations of probability theory is the concept of an independent event - an event that occurs regardless of the outcome of the preceding event. The classic example is flipping a coin. The outcome of each toss is "independent" of the prior toss.

If events are independent, we can determine the probability that a particular sequence (or "string") of events will occur by simply multiplying together the probability of each individual event. For example, the probability of throwing the given sequence four heads in a row with a balanced coin is:

`0.5 x 0.5 x 0.5 x 0.5 = (0.5)4 = 1/16 = 0.0625`
This same methodology can be used for an unbalanced coin; for example, one that comes up heads 60% of the time and tails 40% of the time. What is the probability of the sequence of throwing two heads in a row with this coin? Since the probability of throwing a head is 60% (0.6) and since the tosses are independent, the answer is:

`0.6 x 0.6 = 0.36 = 36%`

The probability of the sequence being two tails is:

`0.4 x 0.4 = 0.16 = 16%`

The probability of the sequence being a tail followed by a head is:

`0.4 x 0.6 = 0.24 = 24%`

You get the idea.

...Continued in the July 2001 issue of Technical Analysis of STOCKS & COMMODITIES

Wolf von Rönik is founder and owner of Portfolio Analytics, Inc., a financial analysis firm that provides customized optimal portfolio construction, analysis, and tracking for high-net-worth individual investors and small businesses. He can be reached at interconltd@juno.com.