Tuesday, January 20, 2015

Best Practices in Trading: Accepting Uncertainty

Success in trading requires the ability to act decisively in the midst of uncertainty.  Even when a trader possesses a durable edge in markets, the random variation around that edge makes for a meaningful proportion of losing trades.  Risk management begins with the acknowledgment that we could very well be wrong.  

Today's best practice, submitted by Jonathan Frank, a 20-year old college student and trader, is the conscious acceptance of uncertainty.  Jonathan writes:

"The market goes up and down (crazy, I know) and I have been a successful trader because I know that shit happens that you cannot always prepare for, as happens in life.  You live, you learn, and you move forward.  Once you become okay with this uncertainty, you are ready to hit that buy button.  Until then, you might want to start searching for another Albert Einstein" to come up with the perfect theory and prediction of the future.

"I assess market uncertainty by educating myself on consumer outlooks, job reports, and international events that have direct and indirect effects on the U.S. markets.  I then decide if we are in a state of composure or panic...Market uncertainty is like the weather in that there will always be people speculating about whether stocks are going to go up or down in the future, but unless there is a drastic occurrence you have to be optimistic and know that rainy days are followed by sunshine.  Always."

Jonathan has not been trading for long, but he has come to an important and mature insight:  How we trade depends upon how we assess the environment.  Are we experiencing a normal market environment or an abnormal one?  If we hear a weather forecast predicting a rain storm, we do not freeze and refuse to go outdoors.  We dress appropriately and go about our business, understanding that there is some small possibility that the storm could become something truly ugly and dangerous.  If, however, we notice very ominous clouds and very low air pressure and hear a weather alert, we may very well decide to take precautionary measures and batten down the hatches.

Jonathan mentions data releases and international events as indicators of uncertainty in the world.  In markets, we can also gauge uncertainty by looking at realized and implied volatilities--how much markets are moving and how much volatility is priced into markets via options.  I find that historical analyses of markets also provide a useful gauge of uncertainty.  When we look at where the market stands today and then go back in time and examine all similar occasions, we can get a sense for the variability of forward outcomes.  Sometimes those prospective outcomes contain a directional edge; sometimes they are random.  Sometimes those outcomes are highly variable; other times they are more constrained.  By examining the uncertainty of past outcomes, we can sensitize ourselves to the uncertainty of the immediate future.

Further Reading:  Dealing With the Uncertainty of Trading