Trading, Profitability and Leverage by J.M. Malley
Leverage is a key factor in trading, but few traders understand its importance. Here, Malley concludes his work on the subject.
Modern financial theory proceeds by developing an explicit model and deriving a probability distribution of the outcomes. By contrast, commodity traders have had to content themselves with the odd gambling metaphor instead of a rational use of probability in money management. However, questions concerning the outcome of the very next trade, such as what my probability of winning the next trade is, are not meaningful. But we can ask questions about the probability of the outcomes if we employ a longer-term horizon, where the trader's performance probabilities, as evinced by his track record, have a chance to come into play over a series of trades. Let me show you the probability distribution of the outcomes associated with the model developed in my previous articles on leverage and trading. I will provide some justification for the distribution and demonstrate the mechanics involved.