Do You Have A “Black Swan Robust” Trading System
Nassim Taleb – What Can Forex Traders Learn From The Black Swan” and Fooled by Randomness?
Are you familiar with Nassim Nicholas Taleb and his published work? Taleb has pretty much seen it all as a hedge fund manager, a Wall Street trader and writer of two books which are an essential read for aspiring traders: These books are called “The Black Swan” and “Fooled by Randomness”.
The terminology “Black Swan” comes from the 17th century European assumption that ‘All swans are white’. In this context, black swans are often seen as a symbol for something that was impossible or couldn’t exist.
Taleb’s career in trading brought him a number of large wins with reportedly little to speak of in between. This is pretty much the opposite of how most retail traders approach the market. Retail traders are known to let losing trades run and cut winners short; this group of traders does not place an emphasis on risk. Taleb, on the other hand, would buy out of the money options with the underlying potential to make a fortune if a “Black swan” event came around, as it did during the great financial crisis. In stark contrast to retail traders, who are looking for how much they can win, Taleb has said “My focus is simply risk”. A focus on risk is essential if traders are to have prolonged success; minimising trading risk is the first step towards maximising trading profits.
What Should Forex Traders Look Out For?
So what can the average forex trader take from this? The approach that Taleb takes to the financial markets is to set himself up to benefit from “Black Swan” events and profit from outliers. This does not necessarily mean that the trader is looking for a huge event to come about. A strategy which provides a low risk entry into the market, but has the potential to benefit from large moves, is what Taleb seems to advocate. Any trader looking to utilise this kind of methodology would need to be ready to experience a large amount of losing trades but with a good payoff through letting the winners run.
One thing for sure is that any system based on lots of small wins and the “occasional” big loser is always in danger of experiencing an extended run of losing trades. If a trading system with a low risk reward ratio is backtested – showing incredible gains – we can’t then place too much weight on past events repeating. To put this another way: seeing an event (or series of events) happen once does not ensure it will necessarily occur again.
How A Trading System Can Fail When A Black Swan Event Happens
With the above in mind, take a look at the following chart: A simple trading system which looked for price to retrace towards the 10 SMA would have made money from the start of 2008 through the end of the year. All previous gains would have been wiped out though as the USDCAD moved ever higher on broad based USD strength near the end of 2008 and a drawdown of over 200 pips would have been an account killer for many.
Understanding the theories that Taleb presents in his books can prove to be challenging but ultimately rewarding for the reader. The Black Swan” and Fooled by Randomness are two thought-provoking and entertaining books that could give you a fresh perspective on the financial markets.