Wednesday, July 26, 2006

Randomness Revisited

Any seasoned trader will tell you that things in the market, as much as we don't like to admit, are mostly random. Don't believe me? Not a problem, I won't try to convince you and will let the market do that instead (that beast is far better at it than I am anyway). In the meantime I'll share two tidbits of information for your consideraton:
  1. Read Nassim Taleb's book "Fooled by Randomness". Please read all of it, not just the first two chapters. I won't say it's an eye opener, but I will say that it throws a very healthy doze of reality into the trading game. It does this by quantifying some daunting facts and by disqualifying several persistent myths. This isn't the "top ten cardinal rules of trading" - there are so many incarnations of these "rules" that it's probably safe to fade them. No, this is a book about reality. I'd prefer you read this book and become disillusioned by the reality as a result, rather than remain blinsided and get hurt by it.

  2. Below is a an interesting set of charts that show 100 trading days of two stocks. Here's what's fun about them. One of them is a real chart. The other is a purely random depiction of a random-number generator. Experienced chartists among you should be able to tell the difference but once you do, admit that the random chart does throw you a little. OK, maybe more than a little - in fact I am personally amazed by how "real" it feels. Granted, it is missing many nuances that we would find tradable, but the common patterns (straight out of the "Analysis of Stock Market Trends") are right there staring you in the face.
Frankly, after I generated a few of these I have to confess I felt a momentary wave of discouragement. Very momentary though! :) After all, I could tweak the code to generate even better "looking" charts - at random - and fool just about anyone. Heck, some of the charts look so real that I could count Elliot Waves and defend the count with the utmost, nearly frenetic conviction.

Then I calmed down and smiled. Yes, things are quite random and that explans the difficulty of it all. That explains the angst and high cost of entry.

But best of all, it tells you that once you're in you're not leaving any time soon.


Chart 1
Chart 2


At 11:56 PM, Anonymous Anonymous said...

if you found Taleb's book to be insightful, how do you reconcile that with your strategy of selling premium? and taking delta risk in addition?


At 5:55 PM, Blogger Dmitry said...

It's a good question. Obviously I do agree with Taleb's notion that the actual, "realized" tails are thicker than assumed by the market. Knowing this my business is to find distributions where the tails are "priced" thicker than they should be.

Taking delta risk is exactly what makes the above possible as the skew in distribution is usually of a directional (not vol) nature. Basically, the skew has only one of its tails that's thick. The other side is thin or non-existent. With vol reversion and positive theta added to the skew there's just enough edge that can be gathered from a substantially diversified basket of equities.


At 2:59 PM, Anonymous Anonymous said...

best regards, nice info


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