This is by far the most important topic in Trading Forex. This blog is going to explore the law of large numbers. And the failure to understand this subject is the number one reason why most traders fail in this business.
Firstly, you need to learn about probability, which is the statistical likelihood of an event or events happening in the future.
The easiest way to understand probability is by using the common example of the coin toss. For example, an evenly weighted queen with heads and tails as the two possible outcomes has a 50-50 chance of happening. If you toss the coin 10 times by the laws of probability state, you should get five heads and five tails. But in reality, you may get 6 heads and 4 tails or 7 heads and 3 tails.
Why? Because this sample is very small and it's not giving the laws of probability enough time to play out. If you toss the same coin 10,000 times, you'll get pretty close to a 50-50 distribution. The reason is that on bigger sample size, the outcome is much more predictable.
Why is this relevant in trading? If you have a good back-tested strategy you should know what to expect going forward so you need to understand the laws of probability. This way you won't throw out the strategy after such a small sample size and you'll be giving it more time to play out.
How the law of numbers helps you in Forex Trading?
To understand the law of large numbers thinks for a second at the insurance market.
Let's assume you want to get life insurance. After you give the company all the information about you, they're going to look at the big population and come up with a statistical likelihood of how much you're supposed to live. The insurance company might say you're likely to live 86 years old. But in reality, the chances are you won't die at this specific age.
Point being here is the insurance company won't throw away all the past medical history and all the research made on that big population, just because they got one wrong.
So the law of large numbers says to not worry about the short term and the minor fluctuations but keep with it because in time the bigger population will pan out. Do not throw out the strategy just because you got a few wrong.
What is the equity curve?
When back-testing your strategy, you see the equity curve which has the time on the horizontal axis and the value on the vertical axis. So the strategy expectancy should look something like this:
If you have a good strategy that you backtested, but inevitable appears a losing period, you'll start losing money. This can happen even if you have a positive expectancy which is supposed to deliver a good return on investment. Every strategy will have a losing period.
So the premise behind the law of large numbers is to look at your trading in the big picture. Don't stress out about the now moment and let the strategy play out. Have faith in that strategy and don't throw it out or tweak it because of the inevitable losing periods.
I hope you have found this valuable. If you would like to learn more, join me in the Trading Room. I hope to see you there! Happy trading and good luck.