Enhancing Trading Decisions with Probabilities: A Bayesian Perspective

In short-term trading, making informed decisions is crucial for success. One powerful tool that
traders can utilize is Bayesian analysis, which allows for the incorporation of new information
into decision-making processes. In this blog post, we will explore how Bayesian analysis can
enhance our trading strategies by adjusting probabilities based on observed outcomes and new
market data, using real stocks such as NVDA and MSFT to provide practical examples.

Learning Outcome 1: Define a random variable, an outcome, and an event

A random variable is a variable whose value is determined by chance. An outcome is a possible

value of a random variable. An event is a collection of outcomes.

For example, the stock price of NVDA is a random variable. Possible outcomes for the stock
price include $100, $105, $110, and so on. An event could be the stock price closing above
$100.

Learning Outcome 2: Identify the two defining properties of probability, including

mutually exclusive and exhaustive events, and compare and contrast empirical,
subjective, and priori probabilities

The two defining properties of probability are that it must be between 0 and 1, and that the sum
of all probabilities of all possible events must be equal to 1.

Mutually exclusive events are events that cannot happen at the same time. Exhaustive events
are events that cover all possible outcomes.

Empirical probabilities are based on observed data. Subjective probabilities are based on
personal judgment. Priori probabilities are based on prior information.

For example, the probability of the stock price of NVDA closing above $100 could be based on
empirical data, such as the stock price's historical performance. It could also be based on
subjective judgment, such as the trader's belief that the stock is undervalued. Or, it could be
based on prior information, such as the release of positive earnings news.

Learning Outcome 3: Describe the probability of an event in terms of odds for and
against the event

The odds of an event are the ratio of the probability that the event will happen to the probability
that the event will not happen.

For example, if the probability of the stock price of NVDA closing above $100 is 0.6, then the
odds of the stock price closing above $100 are 6 to 4.

Learning Outcome 4: Calculate and interpret conditional probabilities

Conditional probability is the probability of an event happening, given that another event has
already happened.

For example, the conditional probability of the stock price of NVDA closing above $100, given
that it opened above $95, is higher than the unconditional probability of the stock price closing
above $100. This is because the stock price is more likely to close above $100 if it opened
above $95.

Learning Outcome 5: Demonstrate the application of the multiplication and addition rules
for probability

The multiplication rule for probability states that the probability of two events happening together
is equal to the product of the probabilities of each event happening.

The addition rule for probability states that the probability of two events happening, either one or
both, is equal to the sum of the probabilities of each event happening, minus the probability of
both events happening together.

For example, the probability of the stock price of NVDA closing above $100 and the stock price
of MSFT closing above $200 is equal to the product of the probabilities of each event
happening. The probability of the stock price of NVDA closing above $100 or the stock price of
MSFT closing above $200 is equal to the sum of the probabilities of each event happening,
minus the probability of both events happening together.

Learning Outcome 6: Calculate and interpret the expected value, variance, and standard
deviation of random variables

The expected value of a random variable is the average of all possible values of the variable.
The variance of a random variable is a measure of how spread out the values of the variable
are. The standard deviation of a random variable is the square root of the variance.

For example, the expected value of the stock price of NVDA is the average of all possible stock
prices. The variance of the stock price of NVDA is a measure of how spread out the stock prices
are. The standard deviation of the stock price of NVDA is the square root of the variance.