Research HUB: Thinking in probabilities
There is no certainty
Hey everyone,
I want to touch on a simple idea: always think in probabilities.
This may seem obvious to those who have been in markets for a while, but in reality, it is probably one of the most overlooked aspects for new traders.
Thinking in probabilities is crucial because the market is continually in the process of pricing the probabilities around uncertainty. There are two ways I think about this concept:
First, to analyze the market effectively, you need to evaluate HOW the market prices probabilities. For instance, the options market for any asset prices BOTH left and right tails. This is why call skew or put skew can send a signal in terms of positioning pricing probabilities.
Second, if I only consider deterministic outcomes and everything in between as the market being “wrong,” I will never be able to make as much money. Thinking in terms of probabilities actually helps you make MORE money.
What I see quite often is people confusing conviction with deterministic thinking. For example, there is a famous scene in The Big Short where Michael Burry discusses his trade as a certainty. I believe these types of stories create a bias for people to think that conviction equates to having “certainty” about a trade.
One way I think about assets is HOW they price probabilities as information shifts across the spectrum from uncertainty to certainty. For instance, I don’t technically know what the inflation print will be in 12 months. As we move closer to the inflation print that will occur in 12 months, we gather more and more information about what it is likely to be. However, the world is constantly changing, so the actual inflation print can be dramatically different depending on the unknown events that transpire between now and then.
Instead of attempting to take a binary view about inflation being a specific number in 12 months, I simply want to identify when the market is likely pricing in an unrealistic probability and continuously take the other side of that with proper risk management. This is a crucial logical shift because instead of taking a stance on what I believe will happen in 12 months, I can merely form opinions on what I DON’T think is probable.
This way of thinking in probabilities, scenarios, and embracing uncertainty contradicts how financial news media communicates. Media fundamentally needs to sell certainty because it appeals to human nature. (Check out this video of the Goldman CEO talking about this concept: Link)
I have mentioned this in a previous article, but one of the best traders I know will always say, “Yeah, maybe.” Anytime he is pitched a trade idea that might sound perfect, he just says, “Yeah, maybe.” Anytime a market view is provided, he just says, “Yeah, maybe.” This might sound annoying, but after you execute enough trades, you realize everything is a “Yeah, maybe.”
Maintaining this mindset is difficult for two reasons:
First, reductionist market narratives always appeal to us, and there is always this illusion in the back of our minds that we can “figure it out.”
Second, being wrong A LOT can really beat you down sometimes if you don’t view things in probabilities.
Here is a great technical definition of probabilities from Options Volatility and Pricing:
You can begin to see how thinking in probabilities begins to frame what we call “edge” in the market.
I will end with this: it's always easy to tear apart people's views in retrospect because, by definition, the majority of them will be wrong. The real question is how you manage your losses and amplify your gains.
Thanks for reading!
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Previous article covering bonds and SPX:
