This is a guest post from Rajesh that blogs at Nifty Nirvana. Knowing why something works can be the key to everything:

Trading is a probability game. Right. I do not want to dispute that. I know very well that there are no certainties in Markets, only probabilities.

 But I can’t agree with the way many traders approach these probabilities. For example, take the case of “Gap closure”. People research and conclude that during the past 70% of the time, morning gaps closed. They bet on this probability and act on it. They believe the probability will work in their favor and in the long run and they will emerge as winners.

Usually Traders focus on one important technical set up and start tracking it. They do back testing and forward analysis on this technical set up for a while and compute the basic probability ratios for this. When they find this ratio favorable, they conclude that the pattern has a lasting and significant edge in the Market.

I approach this problem differently. Rather than finding the basic probability of the set up and betting on it, I try to find out the factors that made the set up work. I have drawn my inspiration from the Pharmaceutical Industry.

For centuries people relied on traditional medicines like plant extracts. Many of them were found to be very effective. The problem is these botanicals and herbal preparations contain various bio active components and identifying the exact effective component is a challenge.

First step is the extraction, isolation and characterization of active components in these herbal preparations and finding the exact effective molecule. Toxic studies and clinical evaluation follows before the drug is released. Easier said than done

I feel this is the right way to go. Instead of betting on the basic probability, we must go deep and find out the patterns inside these patterns. Identifying and isolating these favorable conditions will give us the real trading edge, I believe.