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.

Donald Rumsfeld, Paul Tudor Jones, Facebook and Twitter

“I don't risk significant money in front of key reports, since that is gambling, not trading." - Paul Tudor Jones

When you are trading, the only elements you can control is when to enter a position, where you place your initial stop, your position size and the amount you are willing to risk.

Once you are in a trade, you have no influence over what will happen - the market (being other buyers and sellers) will determine future price direction, and consequently whether your position goes into profit or a loss.

You of course do have control over where you place your initial or trailing stop, but you do not always get out at those prices - particularly if you end up on the receiving end of a price shock and a resultant gap against you. As a result, there is always a risk that you can lose more than your initial risk on any trade.

Earnings releases are, in Rumsfeld-speak, a "known unknown". We know when they will occur, but we cannot predict or quantify their effect on price. Therefore, there is always potential downside risk attached to them. Some announcements may see price move in your favour, others can go against you.

This week we have seen two big-cap Nasdaq stocks suffer large price gaps following earnings releases. The charts of Facebook and Twitter are below.

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.

Larry Hite and the EU referendum

"When I was a kid and got my first motorcycle, I had an older friend who would always get into fights. He told me, "Larry, when you are on a motorcycle, never argue with a car."" - Larry Hite, from his Market Wizards interview

This week I have been reminded of the above analogy when thinking about the EU referendum here in the UK. This is a classic example of a major 'event' which may (or may not) cause significant volatility and movement in the markets.

Trend following and Donald Rumsfeld

Embracing what is said here is part of a trend followers core mindset and beliefs, don't you think?

Here is another Rumsfeld quote that, again, can easily be related to trend following:


"I would not say that the future is necessarily less predictable than the past. I think the past was not predictable when it started."

I'll let you ponder on those.

Trading and Donald Rumsfeld

Here's a couple of famous quotes from former US Secretary of Defense, Donald Rumsfeld, which can easily be applied to trading, and in particular, to the core element of risk management: