ANALYTICAL TOOLBOX: Beware the Black Swan
June 14, 2007
Saturday’s OASIS discussion on probabilities in trading provide a great follow-up opportunity to discuss the downside of applying probability analysis into trading—low probability market events that can eat you alive. The current stock market environment also sets the tone for the topic. So whether or not you caught the session, keep reading.
The Black Swan
In his book Fooled by Randomness, Nassim Taleb reminds traders that while market returns can be described by a normal distribution (a.k.a. “Bell Curve”), the fact remains that not all returns fit nicely into this model. In addition to past observations that fall at the far end of the curve (“tails”), it is always possible to have a new observation that deviates even further from past results. It’s important to trade mindful, not necessarily fearful, of this fact.
Figure 1: % Change Data for the Technology Select Sector SPDR* (XLK)
(Click here for larger view.)
* Registered Name
The black swan reference comes from philosopher David Hume and reads as follows in Taleb’s book:
No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.
Though probabilities provide traders with tools for decision-making, these measurements should not be used as justification for leveraging risky positions. The book provides examples of extremely low probability events that have wiped out professional traders (and probably a few retail traders) along the way. The markets remain random, preventing either significant computer power or the trader in sync with the current ebb and flow from predicting the future.
With that statement in mind, this is not a prediction for what’s to come in the US equities markets over the next few days, just a reminder that anything is possible going forward. It may be particularly useful if you haven’t yet traded in an environment with strong declines. Assuming you’ve already managed the risk for your current positions, let the markets dictate your next course of action.
System Exits
When developing a system, it’s best to allow the system to determine the stop level. This can be accomplished by testing the system without stops and analyzing drawdown results for the trades generated. Assuming a stop can be established that maintains stable system profitability and is consistent with your risk parameters, it warrants consideration.
Regardless of system rules or stop points you employ, overnight gaps remain a market risk that could result in losses exceeding expectations. In the event you do not employ physical stop orders, be sure to avoid rationalizing events by assuming your system or approach has taken such drops into account. You need to exit trades as your trading plan dictates. In the words of Sheldon Natenberg in the book Option Volatility and Pricing, “One shouldn’t confuse unlikely and impossible.”
Although bounces occur all the time, it’s better to trade in a manner that recognizes the potential for atypical market movement and manages your risk. Don’t kick yourself if that bounce occurs—while you may need to consider whether your stop placement is too tight, this is a more manageable issue than piling up losses. Avoid assuming black swans don’t exist because you have seen one.
To see the other articles by this author, please click here.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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