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Archive for April 2011

Fukushima and System Trading Performance

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How system trending works when encountered with black swan events like the recent Japanese earthquake? The short answer is ¨Bad!¨

The backbone of the system trading is finding repetitive patterns in the price behaviour and trade those patterns. As such, system-trading is not suited to profit from low probability events [aka black swan events]. By definition, black swan events have no repetitive pattern and happen so rarely that no system can be designed to capture the price movement.

Some factual information on this can be found in a recent Financial Times article.

What´s worse, black swan events almost certainly ruin system performance for unknown period of time until the price behaviour returns no casual, ¨normal¨ repetitive pattern which is critical to derive profits from system trading.

The system trading portfolio can be protected from excessively negative effects of black swan event through diversification and preset stop-loss level.

Diversification may help. I call it diversification with no limits in the fund brochure. Diversification over asset classes, geografical regions, traders, timeframes, trading styles. Diversification doesn´t remove the risk per se. But it reduces substantially the probability of massive drawdown. Even in our connected world it is highly unlikely that everything goes wrong everywhere and, even it does, the some systems in the portfolio will be negatively correlated and so contribute to a more stable portfolio performance.

Preset stop-loss level may help as well. The obvious ones are stop-loss levels for each system and the portfolio as such, but also per day, per asset class etc. Once black swan event unfolds and the portfolio value fluctuates out of ordinary levels (be it negative or positive), it makes sense to suspend trading until the fluctuations return to their usual repetitive pattern [so instrumental in process of extracting profits from the market via system trading].

 

Written by A.S.

April 8, 2011 at 11:30 am