Monday, July 19, 2021

More on knowns, unknowns and risk

The recent passing of Donald Rumsfeld caused me to reflect again on his (in)famous "known knowns, known unknowns and unknown unknowns" speech (see here), but the truth is that we always have such instances possible in the markets, at any time.

A lot of people think they know what can or will happen. In reality, there is ALWAYS risk in the markets - there are unknowns ready to happen. And, whether they are known or unknown, the effects on the markets you are trading are impossible to quantify beforehand. Therefore, when interacting with the markets you are exposed to more than anything and everything you will know.

These unknowns are not controllable. Therefore you need to protect yourself when an unknown (whether it is known or unknown) strikes. 

In my own case, I focus on what I can control - my buying and selling actions, and most importantly my position sizing and level of risk. This is key in attempting to minimise the potential downside when combatting the unknowns.

When the unknown unknowns become known knowns these drive price shocks or gaps up and down. For many, a dramatic case in point was the Swiss Franc price movement in January 2015.

9/11 was also an unknown unknown, resulting in the US stock markets being closed for a number of days.

Here in the UK, the 2016 Brexit referendum was an example of a 'known unknown' - we knew it was happening, but the result was too close to call, and no-one knew the potential ramifications and impact on the markets.

Here is what I wrote the day before the vote, and here is the story of how another trader dealt with this event.

For me when trading stocks with my chosen timeframe and parameters, a scheduled earnings release is a known unknown, and as a result I avoid initiating a position in a stock when an earnings release is imminent.

At that point in time, I am reminded of what Paul Tudor Jones said:

"I don’t risk significant amounts of money in front of key reports, since that is gambling, not trading."

While you can read about Richard Dennis stating the need to think in term of extremes, and to expect the unexpected, actually seeing something like the Swiss Franc event happen made me respect the unknowns even more. You are always learning and evolving in this game.

Remember, trend following is designed to capture absolute returns by cutting losses and letting profits run as far as possible. 

That never changes, but a trader's approach to risk can change as a direct result of experiencing or witnessing something like the Swiss Franc event.

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