Saturday, June 10, 2017

Known unknowns and unknown unknowns

As traders, we have to accept that we do not know what is going to happen in the future. While our chosen method would look to to profit from an 'edge', based on some form of probability or odds (e.g. trends tend to persist until they don't), we should never approach the markets with an attitude that we can be sure what will happen from one minute to the next, one day to the next, or one week to the next.

Price action in an individual stock, forex pair or commodity can change behaviour at any time.

Therefore, we must account for that possibility in our own method, our mindset and our attitude towards risk.

Once you accept the above, then you will know that there are two basic types of uncertainty in the markets. To paraphrase Donald Rumsfeld, they are:

  • known unknowns; and 
  • unknown unknowns. 
"Known unknowns" would be something like a scheduled earnings release relating to an individual stock. A Brexit vote. The US election. We know these events are happening, but we cannot predict with any certainly the outcome, and the subsequent price direction. At the very least, we should expect increased levels of volatility in the price action. Your own method, timeframe and parameters will help you determine whether you believe you can embrace the anticipated increase in volatility or not.

Then there are "unknown unknowns". These events are where something happens which roils the markets and were not anticipated or scheduled like a '"known unknown". Think of the Swiss National Bank removing the price floor in the Swiss Franc, only days after saying it was a cornerstone of their policy. If you were a day trader, you may consider the 2010 'Flash Crash' as being such an event. Or an unexpected profit warning relating to an individual stock being announced.

Below are recent examples of both types of events:

The "unknown unknown"

A few weeks back, a trader friend of mine experienced one of these situations when his fully automated system got him into an ADR of a Brazilian stock a couple of days before an alleged corruption scandal broke involving the Brazilian President. The Brazilian stock market suffered a major price gap down, and its circuit breakers kicked in. The result of all this was that my friend suffered a loss greater than -6R overnight.

Fortunately because of his overall risk control and approach his loss of equity in percentage terms was contained.

Nevertheless, it was a timely reminder that, due to the inherent uncertainty in the markets, such a price event can occur at any time - and can happen to anyone.

The "known unknown"

This week, we had a such an event in the form of the General Election here in the UK (the actual announcement of the election was completely unexpected and in itself was an "unknown unknown"!).

After returning from a recent break away, I was looking forward to getting back into the markets this week. However, since the election was announced in April, the lead in the opinion polls for the Conservatives had been eroded, placing doubt in the end result - thereby giving rise to uncertainty and a potential increase in volatility.

This made it different, for example, to the recent election in France where Emmanuel Macron had a consistently large lead over Marine Le Pen. Therefore, when considering the risk, I decided to stay out of the market until the result was known. To me, this was no different to avoiding taking a new position in a stock in the run up to earnings - I had no clear edge.

In my own mind, this meant it was similar to the major "known unknown" of the EU referendum vote a year ago. I talked about my attitude towards that here and then how my same trader friend managed to avoid some big losses by accepting he also had no edge. Some you win, some you lose.

If you are a long-term trader who intends to hold positions for many months, then your own method may be better equipped to embrace any volatility which may arise. But, because my own approach is towards the shorter-term end of the scale, I had to consider the volatility and potential risk.

As it was, the markets reaction was to go UP, and the immediate move in sterling was comparatively muted.

Finally, there is a third unknown - that of market intervention. This is another form of an "unknown unknown" but experienced traders also know that this generally happens in response to a recent event or events. Therefore, experienced traders may be able to anticipate this ahead of the intervention and act accordingly.

Perhaps the best known example of this is the US government's reaction and market intervention to the 1987 market crash. Some of the Turtle traders got caught out by this - in his book Way of The Turtle, Curtis Faith talked about suffering an overnight drawdown of 60% as a result of this.

William Eckhardt, on the other hand, was more cautious and covered his position in Eurodollars as "I didn't like the market action". As Ed Seykota said: "Follow the rules without question, but know when to break the rules".

I encountered this in 2008. Back then, I got caught short some UK bank stocks when the FSA banned short selling in a number of financial institutions. Predictably, the stock prices in those companies affected gapped up, taking a chunk of my open profits and getting me stopped out of my positions. Within a couple of weeks, prices had fallen back below where they were before the announcement, and carried on falling for a few months more. C'est la vie...

Everyone will have their own idea of risk and their attitude towards it. My own view this week was to sidestep the risk and wait - yours may well have been different. Either way, you should still have your general approach to each of these types of events covered as part of your trading plan.

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