Psychological Mistake 2 Impact Of The Law Of Small Numbers ~ forex daily trading system free download
In the field of statistics, the law of large numbers tells us that the more times we do something, the more likely we will get results which are consistent with what the system will intrinsically give us. For instance, if you toss an "unbiased" coin, the probability of "heads" showing up is 50%, while the probability of "tails" showing up is also 50%.
However, if you toss the coin 10 times, you may not get 5 heads and 5 tails. Instead, you may get 7 heads and 3 tails, or even 8 heads and 2 tails. If you toss the coin 100 times or even 1,000 times, you are then more likely to get about 50 heads and 50 tails, or about 500 heads and 500 tails. This is why you need a sufficiently large sample of data in order to be able to justify the statistical "evidence" you get.
When trading the Forex market, many traders, by virtue of a short-sighted bias and selective perception, easily come to conclusions about market behaviour based on a small number of occurrences. For example, after getting 2 or 3 losing trades, some traders will conclude that the trading strategy does not work. Such an "it doesnt work" mentality is extremely common among traders who constantly seek after new indicators, strategies and software. This is where the "law of small numbers" works its way into the psychology of traders. It is rooted in impatience and an inability to think in terms of the "big picture".
Similarly, when traders attempting to look for patterns in the behaviour of market prices and indicators, this "law" often distorts their analysis. This is where the tendency of selective perception causes many of us to see patterns and arrive at conclusions based on selected occurrences of these patterns.
Thinking in terms of probabilities is an important mental habit that all traders must cultivate in order to be successful in this business. In order to overcome the influence of the "law of small numbers", a traders must understand the following principles:
- Probabilities work out over a sufficiently large number of trades
A trader must not only realize this principle at the intellectual level, but also at the behavioural level. It is typical for traders to say, "Yes, of course! I never expect winning trades all the time. If I can get a 70% win rate, I will be extremely happy!" However, as soon as they start taking "real time" losses, they naturally allow the immediate feelings associated with the losing trades to overwhelm them. They start losing faith, feeling discouraged, or even complaining about their trading strategies. This behavioural pattern is so common because human are by nature short-sighted, whereas probabilities involve a "long-sighted" mental attitude. - Representative samples of historical data must be used in order to justify probabilities
There are many software programs and indicators available to aspiring traders, displaying extremely promising back-testing results. Sometimes, these back-tests seem to involve reasonably long historical periods. However, many people do not realise that trading rules can be manipulated to fit the market movements in a certain period of time.
When testing systems, the historical data being used need to represent a sufficiently wide spectrum of market patterns. Whenever statistical surveys are done on a certain population in a large country, it is impossible for the study to incorporate every single individual in the populations. As such, in order to make the statistical study valid, it must include different aspects of the population, i.e. selecting individuals from various age groups, races, religions, educational backgrounds, etc.
Similarly, a realistic testing of a trading system must involve a wide spectrum of different market scenarios such as trending, ranging, quiet, volatile conditions and rare market events. This will enhance our confidence that a tested trading system is likely to meet our trading objectives when applied "live" in real-time market situations.
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