Tag Archive: Fooled By Randomness

Cover of "The Black Swan: The Impact of t...

Cover via Amazon

I am going to touch on a topic that has been made popular over the past few years as a result of the wildly successful book by Nicholas Nassim Taleb “The Black Swan“. I found his  fooled by randomness to be much more interesting, but both are must reads to anyone interested in the market and how we perceive everyday events. The author has a few detractors in finance, academia and the media. You shouldn’t let these deter you from what he has to say as he has yet to  experience the failure that some of his most vocal detractors have.

Nicholas Nassim Taleb must be thought of first as a pursuer of intellectual truth and knowledge, second as a trader and financial commentator. I share with him a desire for independence and freedom from authority and believe that trading can offer that. His most profitable trades have arisen due to misconceptions about risk and chance. Two topics of vital interest to traders.

A “Black Swan” event is the occurrence of a highly improbable event that has extreme implications. Black Swans are the outliers on a data set. If you were to ask where a black swan would show up on a Bell-Curve it would be to the extreme left or right. The two tails of the curve. They are often times the most ignored, yet most important aspects of a data set.  So a black swan trade would be to trade an event that is highly improbable of occurring, but in the case that it does, results in a large or even immense payoff.

The exact opposite of a black swan trade would be to trade an event with a high chance of occurring with a small payoff. An  example of this is given in another great book When Genius Failed by Roger Lowenstein in which he highlights the implosion of Long-Term Capital Management. LTCM was a fund created by some of the most elite and revered names in finance. Their trading style was to find high-probability, low payoff events, leverage the trade by on average 20:1 and hope that the black swan never crossed their path. Well as is often the case in matters of trading, the black swan decided to make its presence known. What resulted wasn’t on the scale our most recent economic crisis, but the fed had to step in with its strong-arm tactics forcing Wall Street’s major players to bail out a group of academic legends.

If you chose to become a black swan trader you will experience bouts of depression and self-doubt as most of your trades end up as losers, if you are able to withstand the psychological assault that this style provides then at the end of the day you will have achieved the independence and freedom from authority that we all pursue. If you chose the LTCM path and many of you will, you will experience a life of satisfaction, but be forewarned that it is a life lived on borrowed time.  For the Black Swan comes swiftly and witthout warning.

Isoalpha isn’t the proper forum for me to offer advice on trades that you should make, my goal is to make you aware of mistakes that can be made. To become a successful trader you have to be aware of your biases and how they affect the decisions you make while trading. You must be willing to look at the data in a different light and constantly question your rationale for making a trade. Just because you can backtest a strategy and found that it has been successful using historical data, doesn’t guarantee that it will be successful tomorrow. It doesn’t mean that you shouldn’t execute it, just be aware of the consequences that will occur if your theory isn’t valid in tomorrows market. If those consequences are bearable then by all means make the trade.


The Business Press

We cannot avoid the onslaught of financial advice and entertainment
in today’s society.  Some good comes of
it, we get to experience Schadenfreude when the latest corporate executive is haled
of in hand cuffs. But much of what is on CNBC, FOX Business, and their  ilk is of no real value to you as a trader.
Every once in awhile you will see, read or hear something that you feel will
benefit your trading day, but once we hear it has about, the likelihood that
you will be able to realize a return on investment that can be specifically
attributable to that piece of news is highly improbable.

I don’t advocate that you disregard everything that you hear
outside of a boardroom or trading floor, just don’t use it as justification to
put your capital at risk. If you have a disregard for money there are millions
of other ways for you to show that disregard that will bring both you and the receiving
party more satisfaction than following another one of Cramer’s trades.

I have had the fortune (some would say misfortune) to read a large
number of memoirs by current and former traders. While I felt that I was able
to take something from each book I read, I can honestly say that the memoirs of
Victor Niederhoffer http://en.wikipedia.org/wiki/Victor_Niederhoffer  and Nicholas Nassim Taleb http://en.wikipedia.org/wiki/Nassim_Nicholas_Taleb had by and far the most
qualitative and quantitative affect. If you choose to read my blog with any
regularity you will become as familiar with their personal philosophies and
professional trading styles as I have.

I won’t delve too deep into who they are, what they have
accomplished and why they matter. I have included a couple of links in case you
are the inquisitive type like myself and must know now. I can safely say that
their trading styles are as different as night and day. However they do agree
on the fact that you will gain absolutely nothing, and will in fact increase
the probability that you will have a losing trade,  if you base your trade off of something in
the financial press.

One thing you must remember whether you are trading or investing
is that financial journalists do not have their jobs because of their ability
to analyze the market. (Then again the same can be said of some fund managers!)
If you must rely on someone else for trading ideas and you don’t have the
ability to have your money manager at an address in Greenwich CT. you’re better
off asking someone who has absolutely no exposure to the markets, than someone
with superficial knowledge.