Outliers (August Blow Up)

Interesting article on the MIT Technology review (here), pointing out that most quantitative models on Wall Street make assumptions about the relationship between instruments and are subject to the "black swan" problem, not properly recognizing "unexpected" outliers in their strategies.

In the context of automated strategies my view is that it is fine to work within the assumptions of "normal" market behavior, provided that one has a risk management strategy to contain losses from outlier events to an amount that will not significantly erode accrued profits. To not do so is an opportunity lost.

Fooled by Randomness

I'm on a trip, in Japan right now. Bought "Fooled By Randomness" by Nassim Taleb, at the airport and have begun to read. Highly recommend this book for anyone trading or otherwise involved with trading.

The book is a discourse in objectivity, particularly in relation to trading decisions and performance. One of his assertions is that many traders build a career around what has worked for them emperically rather than statistically sound judgement (I agree). That a portion of these traders succeed has more to do with the short sample period (trading career is generally short).

I have seen this time and again on Wall Street. Trader does well for some years and then blows up. Wall Street firms presents a free option for traders. The trader locks in his profits on an annual basis with bonus, where as the firm absorbs the downside of:

• trader losses
  
• longer term performance of their portfolio after trader leaves
  

He cites 2 traders, one who has taken a conservative approach through his career, valuing all outcomes in his trading and another more typical trader who made 10x more than the former trader, but whose approach was more subject to randomness in the market and in the end loses his job / career.

One could say that the conservative approach requires two things:

• rock-solid risk management, anticipating even low probability events
• better evaluation of the "expectation function" by summing all possibilities with their associated probability