Monday, October 15, 2018

How To Prepare For Challenging Trading

If Noah had waited for the storms and floods, it would have been too late to gather the animals and build the ark.  Our role as traders is to prepare for possible adverse outcomes so that we can ensure our survival should one of those materialize.

How can we prepare properly?

In the recent Forbes article on how to navigate these volatile markets, I make the point that a close examination of similar historical periods can help us anticipate a variety of scenarios: both ones of risk and ones of opportunity.  It's not that the immediate future will replicate any of the past price paths in similar circumstances.  It's that the past price paths can tell us what is possible--and maybe even what is likely--going forward.

So let's take a specific example.  I recently noted that we had made a multi-standard deviation move to the downside--over five standard deviations, to be precise.  In similar situations going back to 1993, we were up 11 times, down 4 over the next five trading sessions.  Of the four down instances, all were lower by more than 2%.  Of the eleven up instances, six were higher by more than 3%.  Volatility was the norm and bounces were common.

Psychologically that alerted me that, even though I thought we could see further downside, I had to be prepared for short squeezes.  In fact, those have been more common in the past than not.  The past instances also alerted me to the likelihood of further volatility, which led me to temper my position size.  When we traded weak in morning hours, I took an initial short position, saw it go my way modestly, and then bounce higher.  The quality of the bounce made me take notice, as it demonstrated a shift in the amount of movement per unit of volume--something I describe in the Forbes post.  I quickly covered my short position for a small loss and avoided a larger drawdown.

Knowledge of the past prepared me for possible future outcomes.  It helped me stay open minded--and that helped me manage risk.  In trading as in sports, preparation primes us for action and that builds our mindset.

Further Reading: