Probability Box Rule of Thirds [PPI]

22 Jun 2023

█ Probability Box Rule of Thirds

The Probability Box Rule of Thirds, is a visual indicator that helps traders identify possible overbought and oversold conditions. It does this by dividing the price range – highest high minus the lowest low of a given lookback period or date range – into thirds. Each third has distinct probability characteristics and when combined represent a probability box.

We have spent years refining the probability box concept, and have previously published a How To on Trading View – "How to Trade Probability Ranges – The Critical Rule of 1/3" which can be found here:

https://www.tradingview.com/chart/MATICUSD/PBEhen0B-How-To-Trade-Probability-Ranges-The-Critical-Rule-of-1-3/

To quickly summarize the How To – when using the Rule of Thirds, you are using a combination of statistics, probabilities of success, and prior price action to determine when to enter a trade. The visual range division helps remove subjectivity and clearly shows when the trading odds are stacked in your favor. By identifying and taking higher probability trades, you have a higher chance of success as trading is all about probability and risk management.

Implementing the Rule of Thirds starts with finding an instrument that is consolidating and identifying the nearest important support and resistance levels based on your targeted trading timeframe or lookback period.

The range between the support and resistance levels is divided into thirds to form three zones within the consolidation range.

• When going LONG, you want to BUY in the bottom third of the range. Once you buy, your objective is to hold during the middle third and sell when the price enters the top third.
  
  
• When you buy in the lower third, there's a 66.6% probability of success. If you buy in the middle third, you only have a 50% / 50% chance of success. Going long in the top third of the range gives you a 33.3% chance of success as you are already close to the identified resistance level.
  
  
• When going SHORT, the sequence and odds are reversed. You want to SELL in the top third of the range, hold the middle third and exit in the bottom third of the range. This gives you a 66.6% chance of success when entering in the top third, a 50% / 50% chance when entering in the middle third, and a 33.3% chance in the bottom third given you are already close to the identified support level.
  
  
• When the price lies in the middle third, the even 50% / 50% odds provide no probability edge and a trader is better off waiting until the price reaches the upper or lower thirds of the price range.
  
  
• The Rule of Thirds allows us to quickly visually evaluate trades based on probabilities, selectively enter trades that have the highest odds of success, and avoid likely losing trades. The Rule of Thirds gives you confidence to hold trades based on prior trading ranges and provides clear levels where the prices are likely to either reverse or start trending.
  
  
• The Probability Box Rule of Thirds automatically implements the first two steps of the Rule of Thirds by using the highest high and lowest low of a given lookback period to identify the support and resistance levels, and automatically divides the range into thirds. The rest of the Rule of Thirds rules remain the same.
  

Just having the price within the bottom thirds or top thirds, however, does not mean the price will immediately reverse. The GE chart below is an example of a stock that remained 'stuck' in the upper thirds of the price range for an extended amount of time:



And the CVS chart below is an example where the price is 'stuck' in the lower thirds of the price range:



While the price is in the upper or lower thirds, it is very important that the trader should use other indicators to identify when a significant trend reversal occurs. Once a trend reversal event happens, the trader either enters a trade AND/OR exits a trade if already in one.

When the price exceeds the bounds of the probability box, there are three possible outcomes – a strong continuation trend, the price consolidates around the probability box edge, or a trend reversal. Your favorite indicators will help determine which event is happening.

The CVS chart above is a good example of the probability box being exceeded with the last bar. The price exceeding the price range is temporary event as the price range will expand to encompass the revised price range on the next trading day.

█ Indicator Features

• Each supported timeframe – Monthly, Weekly, and Daily – allows the selection of an appropriate lookback period for your trading style. The defaults are a good starting point for swing trading and long-term investing. You many need to experiment to find the optimal lookback period for your trading style.
  
  
• Even if you only day trade, the Probability Box Rule of Thirds with the appropriate lookback periods can help you visualize the bigger picture of where the instrument is heading.
  
  
• When viewing the charts, you can find the currently selected lookback period above the upper edge of the price range.
  
  
• The indicator will display a dotted yellow line at 50% of the price range and show the line's value when requested.
  
  
• The visibility of the actual thirds and border price values are controlled by the " Show Probability Box Values " checkbox. You may need to expand the chart's right margin to see the values.
  
  
• The " Show Internal Labels " checkbox controls the display of the internal ⅓ Division labels and the percentage odds, along with the 50% label. This option by default is set to off.
  
  
• The " Show Error Messages " checkbox controls the display of error messages and by default is turned on. Turn off to prevent error messages from being shown on intraday timeframes. Save as indicator default to prevent having to turn off this setting each time added to chart.
  
  
• The color and transparency controls allow the user to modify the colors used for each third. The default settings are optimized for use with a DARK background.
  

█ Implementation Notes

IMPORTANT - the Probability Box Rule of Thirds is set up to only handle Monthly, Weekly and Daily charts. This is intentional as the indicator is designed to be used for safer multiple day and longer swing trades. When viewed on intraday charts, the indicator will be hidden.

The Probability Box Rule of Thirds uses a rolling window of the equivalent number of bars for the lookback period rather than relying on the bar starting and ending dates. This allows the use of a standard number of days in the selected lookback window across various instruments and ensures fast, efficient calculations.

The lookback periods are adjusted when non-standard timeframe multipliers are used – e.g., a 12M chart timeframe and a 3-year lookback period will result in a 3 bar lookback. Fractional bars in this calculation are rounded up and any incompatible lookback period and chart timeframe combination will generate a runtime error.

In summary, the Probability Box Rule of Thirds automates and visually identifies overbought and oversold areas, which combined with the Rule of Thirds probability risk profiles, increases your odds of success through better trade selections and higher confidence in your trades.


█ Disclaimer

There is substantial risk in trading. Losses incurred in trading can be significant. Only trade with money you can afford to lose. We make no claims whatsoever regarding the impact of past or future performance on your trading results.

22 Jun 2023

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