How to trade during market crashes and celebrity sell-offs? Let "probability thinking" help you make high-probability trades.
Crypto trader Cobie recently published an article on trading, incorporating Probabilistic thinking into the market by categorizing possible outcomes in the future to find the most suitable investment approach. Below is the key points and translation of the article.
Original article: "Probabilistic thinking"
Table of Contents
Probability Thinking
The chart below shows the closing price of ETHUSD on May 19th last year. ETH dropped from around $4,400 to below $1,800 in 8 days.
During such a market collapse, four possible scenarios can be considered:
1. The market has already gone through a bull-bear cycle similar to 2017 with the top reached, and the market will decline after forming the "right shoulder".
2. The market will experience a double bubble similar to 2013, currently cooling off and expected to rise again by year-end.
3. The market will face an unprecedented bear market with continuous declines ahead.
4. The market will quickly recover and surge to break new highs.
The above four scenarios are not exhaustive, and each situation may vary slightly, but these are the most likely future scenarios for Cobie. After considering all possible outcomes, excellent traders will evaluate the likelihood of each scenario happening.
- p1 = 45%
- p2 = 45%
- p3 = 5%
- p4 = 5%
In reality, scenarios one and two are the most likely to occur, with the same probability. However, scenarios three and four also have their possibilities. After evaluation, each scenario corresponds to specific trading actions:
- Scenario 1 ── Buy low and sell after the right shoulder pattern is confirmed.
- Scenario 2 ── Buy low and hold for a long-term breakout to new highs.
- Scenario 3 ── Sell early as the price is expected to plummet to zero eventually.
- Scenario 4 ── Buy low and expect a breakout to new highs by the day's close.
Considering the above possibilities, there is a 50% chance of breaking new highs, 45% chance of selling slightly below the previous high, and a 5% chance of suffering significant losses.
More specifically:
- There is a 45% chance of gaining +80% profit by buying at $2,000 and selling around $3,600 after the right shoulder forms.
- There is a 50% chance of gaining +100% profit or more by buying at $2,000 and selling after reaching new highs.
- There is a 5% chance of experiencing a -20% loss by buying at $2,000 and stopping at $1,600 in case of a market decline.
Trading becomes systematic after analysis, with a high probability of profit at 95% and the potential for over 80% profit, making it seem worth the risk. Evaluating the possibilities also reduces the likelihood of panic selling during a market crash.
Dogecoin and Musk
The relationship between Dogecoin and Musk is also worth discussing here. Musk has been enthusiastically mentioning Dogecoin on his Twitter in 2019 and 2020, and continued to express optimism when Dogecoin's price dropped below $0.01 in 2021. In the following assumptions, let's assume a price of $0.1.
The future of Dogecoin can be broadly divided into four possibilities:
- Musk continues to publicly endorse Dogecoin, leading to a further price increase.
- Musk continues to publicly endorse Dogecoin, but the price remains unaffected.
- Musk no longer publicly endorses Dogecoin, but the price continues to rise.
- Musk no longer publicly endorses Dogecoin, and the price starts to decline.
Here are the probabilities:
- p1 = 75%
- p2 = 10%
- p3 = 7.5%
- p4 = 7.5%
Given Musk's strong support for Dogecoin in recent years, scenario one is more likely to occur. However, Musk may also be influenced by his compliance team or advisors and cease such behavior.
Specifically, there is an 84.5% chance of a sharp increase, but at the same time, a 17.5% chance of a significant drop. If a 17.5% chance is acceptable, buying Dogecoin seems like a reasonable risk.
How to Estimate the Probability of Each Scenario?
Identifying potential scenarios and estimating their likelihoods are the main issues when making assumptions. Looking at historical scenarios can help in proposing assumptions by considering the following questions:
- Has there been a drop of over 50% while the bull market continued? If so, what was the largest previous drop?
- What happened after a 30% decline in the past? Are there any reasons for different outcomes this time?
- Historically, how did Dogecoin perform compared to Bitcoin during bull markets? Conservatively, what is the target price for the DOGE/BTC trading pair?
- How much did Bitcoin increase from the previous all-time high in 2013 to the next in 2017? Is this growth multiple reasonable compared to assets with similar market caps to Bitcoin in 2017?
- What typically happens when an asset is listed on major exchanges like Coinbase, Binance, etc.?
History may not repeat itself entirely, but historical data from direct or indirect markets can provide insights for future valuation models. It can indicate how prices may change and the likelihood of such scenarios occurring.
Experienced traders have a deeper understanding of the market, consider more complex questions, and incorporate various market indicators such as open interest, order books, trading volumes, etc. Despite history becoming more complex, the overall approach and methods for forecasting remain the same.
Caution for Retail Traders!
Retail traders often struggle to assess the attributes of crypto assets as they are unfamiliar with technical or fundamental analysis. Additionally, they are not adept at evaluating price behavior in crypto assets, as understanding trading concepts, price charts, and financial markets can be challenging. Therefore, when analyzing various possible futures and evaluating probabilities, biases in probability assessment can lead to significant losses.
However, if you are determined to take this risk, remember to slow down during evaluations, start documenting probability thinking in your trading or investment, and reflect upon losses.
In any case, this is not investment advice. I believe that 95% of those reading this should not actively trade in the crypto market. Simply holding the fastest-growing asset class over the past decade is sufficient. It is not worth risking this kind of danger for potential trading benefits.