Trading options in turbulent markets pdf to word
A Fractal View of Financial Turbulence. I suggest you read this book for yourself even though it is not an easy book to read. I am not going to dig deeply into fractals in this post since most of you will stop reading, but I will explain generally what they are. Is what they actually do consistent with what they claim to believe? This issue reminds me of a quotation often mistakenly attributed to Mark Twain: But to say the record of their transactions, the price chart, can be described by random processes is not to say the chart is irrational or haphazard; rather, it is to say it is unpredictable.
Making short-term predictions about how a price chart reflecting the actions of millions of people will fluctuate is more than just hard. Mandelbrot here is talking about an aggregate or macro phenomenon. Will a blind squirrel find a nut once in a while in making a macro predictions that times a market?
But not more than twice in a row. Mandelbrot is not saying that investors should throw their hands in the air and quit, but rather that they should use the tools of probability in a more refined and nuanced way. Risk comes from now knowing what you are doing and avoiding those areas is a very good thing. If you knew exactly where you will die, the intelligent response is to never go there. The same principle applies in investing.
The good news is that there are other approaches to investing which work around the problem Mandelbrot identifies. Why would you try to predict the unpredictable when there are other investing methods that avoid this problem? Why swim across a section of a swiftly moving river containing a deadly whirlpool when shallow relatively easy to cross sections of the same river are nearby? This is especially true since no points are awarded for degree of difficulty in investing.
But they provide estimates of the probability of what the market might do and allow one to prepare for inevitable sea changes. It will invent it where it cannot find it.
The human desire for predictability and order will result in people sometimes seeing patterns that they believe will deliver certain outcomes. This human desire is often encouraged by promoters who know how to turn dysfunctional thinking into cash — their cash.
Unfortunately, our brains can conspire against us when it comes to successful investing. Much of the work a successful investor must do is related to avoiding emotional or psychological mistakes. Even a random number generator will spit out results that a human brain will see as a pattern. There are some traders who try to claim that Mandelbrot borrowed ideas from the creator of Elliot Wave Theory. Mandelbrot himself responded to that claim by saying: Mandelbrot is saying that the reverse is true.
A side bar about complex adaptive systems might be useful here, but must wait for a future post. Until then there is my blog post on Murray Gell-Mann if you are interested. He was interested in describing how markets work and much less interested in the mechanisms. But he absolutely understood complexity. These five approaches are the equivalent of places in a river where the water level is low and crossing is relatively easy.
An investing system that is consistent with some of all of these five approaches has a greater probability of being successful. Real markets are wild. Their price fluctuations can be hair-raising — far greater and more damaging than the mild variations of orthodox finance. That means that individual stocks and currencies are riskier than normally assumed. It means that stock portfolios are being put together incorrectly; far from managing risk, they may be magnifying it.
It means that some trading strategies are misguided, and options mis-priced. But it has always been like that. A single loss could very well sink a big company.
He was not talking about, for example, using certain statistical factors to make trading options in turbulent markets pdf to word term predictions about an index. He was not talking about making predictions about the long term prices of a specific business using microeconomics principles.
Mandelbrot was pointing out that the magnitude of fluctuations will be far greater than many people people imagine. Charlie Munger makes a similar point: Typhoons, in effect, are defined out of existence.
In finance, this concept is not a rootless abstraction but a theoretical reformulation of a down-to-earth bit of market folklore— namely, that movements of a stock or currency all look alike when a market chart is enlarged or reduced so that it fits the same time and price scale. An observer then cannot tell which of the data concern prices that change from week to week, day to day or hour to hour. Fractal mathematics cannot predict outcomes that results from complex adaptive systems but they can tell us that such outcomes will inevitably happen sometime.
All one can do then is prepare for their arrival and wait. People want a recipe so badly that getting over trading options in turbulent markets pdf to word desire arguably requires a process similar to the famous stages of the Kubler-Ross model: Wisdom in no small part depends on accepting what you do not know or cannot know.
There are times to be aggressive as an investor and times to be very cautious. Knowing the difference is critical. In all their drama and power, they should matter most to bankers, regulators and investors.
The FT captures in this paragraph an important point made by Mandelbrot:. Joseph effects — seven fat years here, seven lean years there — occurred when markets were evolving gradually and continuously. Noah effects were cataclysms — the Flood, or the week of September 11when the New York Stock Exchange closed for five days and dropped 7.
Because Joseph effects rule the market most of the time, they are what models measure. But Noah effects trading options in turbulent markets pdf to word and unmake investors. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.
These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding.
The results help to explain why poorly-diversified active strategies most often underperform market averages. In fact, if you look at the actual data of trading, not for every price, but for the important prices on the market, large price changes are observed often enough to matter a lot. Mandelbrot addressed this overconfident view when he said: They are like a shipbuilder who assumes that gales are rare and hurricanes myth; so he builds his vessel for speed, trading options in turbulent markets pdf to word and comfort — giving little thought to stability and strength.
Nor will any of the other quantities trading options in turbulent markets pdf to word out by the pseudoscience of finance: The problem with all these measures is that they are built upon the statistical device known as the bell curve.
This means they disregard big market moves: They focus on the grass and miss out on the gigantic trees. Mandelbrot is pointing out that an increasingly networked world is a much more turbulent and unpredictable world.
Billions of people with supercomputers in their pockets interconnected by networks creates the potential for mayhem in addition to valuable new products and services.
When I hear people talk about a Great Trading options in turbulent markets pdf to word I want to laugh out loud. The pace of actual change and the potential for more massive new shifts has never been greater. As Charlie Munger says: All of the advantages from great improvements are going to flow through to the customers.
The types of feedback loops that can drive societal, economic and technical change have been put on steroids in this hyper connected digital era.
When you read this it is a good idea to keep in mind this point made by Paul Samuelson: If you can read it, I suggest you buy the book anyway! Microsoft Research talk sorry for the sound quality https: Inequality trading options in turbulent markets pdf to word finance; differences between Bachelier and Mandelbrot https: Physics and Finance https: Low fees and expenses- this approach should never go out of style.
Focus on microeconomic factors impacting specific understandable businesses. Wild randomness is like the gaseous phase of matter: No telling what it can do, where trading options in turbulent markets pdf to word will go.
The fluctuation from one value to the next is limitless and frightening. Mild randomness, then, is like the solid phase of matter: It stays where you put it. Slow randomness is intermediate between the others, the liquid state.
In a review of the book by Mandelbrot and Hudson Nassim Taleb writes: The FT captures in this paragraph an important point made by Mandelbrot: