This podcast episode looks at trading around market extremes, Acts of God, and very large market moves. From market history, some examples might be 9/11, 1987, Fukushima, Katrina, etc. Today, Greece has the potential to lead to these types of moves and extremes. Technical traders need to understand these moves, and to be humble about our ability to predict. In this podcast, I hope to share some ideas about these events–and maybe even to show you how to think about them. Here are the show notes:
- “Acts of God”: a legal (semi legal?) term for events caused by uncontrollable and unforeseeable natural forces.
- These can be:
- Big or small.
- Transitory or long-lasting… but isn’t that the question?
- We are framing the mean reversion / momentum question in a different context here, but the same ideas apply:
- Will the market stop?
- Snap back?
- When and where?
- Generalize this idea to “price shocks”:
- Define: large volatility-adjusted moves, on whatever timeframe you are looking at.
- Unusual, perhaps even rare.
- Classify price shocks:
- with-trend / counter-trend
- clear news explanation / no news explanation
- expectations might be different, depending on category
- Guidelines for managing:
- With these moves, we’re off the map
- There are no magic lines or guides that apply
- Human emotion is driving markets
- The best technical concept that applies is “trading in climax” areas
- One-sided market moves create vacuum. At some point (when?) the market will snap back into that vacuum.
- Large market moves followed by large moves in the other direction usually lead to some type of consolidation or oscillation around a central price.
- The biggest mistake you can make is to assume the move will go on forever. (However, jumping in front of a moving train (substitute whatever analogy you want to make) is also a pretty significant mistake!)
- Is the answer different if you do/do not have a position? Maybe?
- Large gap against position (e.g., 5 year event, not 2 month!) might be one of the few situations in which you want to add to a position at a loss.
- If you don’t have a position, reduce position size.
- You reduce risk and opportunity together.
- You aren’t going to make a killing, but you aren’t going to get killed.
- If you were able to predict the volatility perfectly, you could reduce these events to “normal” trades.
- Hindsight is 20/20. Do the best you can and don’t get run over.
- With these moves, we’re off the map
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Also, if you like the music for this podcast, then be sure to check out Brian Ashley Jones, my friend, and a fantastic singer-songwriter.
Enjoy the show:
just wondering if you would consider the recent sell-off in the China A-share market and Hong Kong Hang-Seng Index as a selling climax? At what point would you look to enter??
I’ll jump on that if it’s ok to chime in. That question depends on your time frame. If you are a swing trader, you don’t really care whether this is a bottom or not, because the rallies on the way down are going to be pretty substantial with this kind of a correction. On the other hand, if one is a long term position trader, you have to recognize the markets were pretty inflated already, then they went up, what, @78% this year? Prices were virtually parabolic, which carries along the people who would normally get shaken out along the way, thereby sowing the seeds of it’s own destruction. They are only into a little over a 30% correction, which isn’t really that much given the precarious state of the markets and the complete inability of the government to stop the selloff. China curtailed margin calls, stopped the social security system from selling, banned the pension funds from selling, outlawed selling by anyone with more than a 5% interest in the float of any one stock, and banned the media from using certain words about the selloff/panic. All of these unprecedented measures, and they are just the ones we know about, did absolutely nothing. Once confidence is lost in a bubble, it’s lost forever.
The old market adage about not catching a knife applies perfectly here, because this is one big knife. If I was going to scalp or swing trade, I’d play ball, but there’s also the risk of the rules being changed by the government/exchange and you losing your money so money management rules still apply. Watch those position sizes.
I remember a quote from Theresa Appleton that I live by, “Traders manage risk, we don’t run from it.”
Brian Fortin
Ken,
What Brian says here makes sense. From a pure pattern perspective, I see a buying climax that is breaking down with nearly textbook precision. Look at the climax examples in my book and you’ll see charts that basically look like China. On shorter timeframes perhaps you have selling climaxes, but looking to buy into this is ultra aggressive / borderline foolhardy (except perhaps on very short timeframes.)
There’s also the very real risk, as Brian said, of someone changing the rules of the game. This has always been one of my concerns with dealing with many Emerging Markets in general (and particularly in Russian stocks, whether that is justified or not.) I’d have the same concerns here… you just don’t know, and there are risks that may go beyond what see can see on the charts.
Pick your spots carefully and think about the risk first of all. In my opinion, there will be a play on China, but I don’t see it yet.
There’s also the psychology issue. When someone asks a guru if it’s safe to pick a bottom, it should raise an alarm, because they may be preparing to transfer the responsibility to guru because they know in the back of their minds they are about to take a big gamble. The answer is easy, don’t take a big gamble. If you have to ask, size down.
My feeling is it’s a good rule of thumb that neither side of the trade is better. Sure, maybe it’s twice as likely the bottom is in, but then the payout may be twice as high if you take the other side of the trade, so neither side is better. Rather than agonize over what side to take, like I used to do, I adjust my position size to my anxiety level and just do the right thing if it doesn’t work out. This has made my life and my trading a lot less stressful. No amount of prediction beats doing the right thing when faced with reality.
Brian Fortin
(Back to the lawn, I am the Budda on the mower today, LOL)
Thanks a lot Brian and Adam for the responses.
I understand that the guru’s advice doesnt guarantee a win, there’s still probability and trade management involved. 🙂
Yup, i read your book (great book btw!) and i thought i saw the climax going up too. But, this week’s sell-off seems a little shocking too. I saw some individual large caps falling almost 10% everyday for the past 3 days, so i thought there might be a selling climax too? Some of these stocks also fell below the rally started, and H-shares didnt exactly benefit as much as the A-shares on the way up.
I guess as Adam has mentioned, there could be some opportunities in the shorter timeframes, but the risk is rather high. The H-shares are now rallying madly at the point of writing (from down 1.5% to up 4%), but i guess the longer term trend remains rather negative still.
Thanks a lot for your advice once again!
This isn’t directly related to this podcast episode, but maybe it can be a topic for future episodes. I’d love to hear more about purely mechanical approaches to trading. Like some of the sample systems in J Schwager’s TA book which seem to exclude the discretionary element completely. Specifically, I’d love to learn a bit about what software/tools an average retail trader can use to design and test a mechanical system.
I’ve had some other questions along these lines. Yes I’ll address it in the future!
Mind-provoking!
When I listened to it the 1st time, I agreed on most/all of the thoughts, but now that I am trying to incorporate some of it into my trading plan I am extremely struggling. On one hand there is this concept of discipline, consistency, following the plan always and on the other hand there is this thought that the day something unforeseen happens (of which probably neither me nor anybody else knows its mid-/long-term impact on prices) you may consider to deviate and introduce some discretion into your process by taking out SL and potentially even adding to the position.
Again, I like this challenging the conventional “wisdom”, but I really wonder how to put this into guidelines in my trading plan… There are so many scenarios, 9/11, tsunami, flash crash, war, that could catch you during market hours, outside, asleep, with positions on, winners/losers, shorter/longer time frame, you could be aware immediately or couple of hours later, impact could be on short time frame or over couple of days/weeks, impact could trigger stops, not trigger, be far beyond stops…
Well, I believe the only addition to my trading plan I can make is that in case disaster hits quickly during market hours, my SL will be triggered either at the intended point or beyond and I’ll be out. If it hits outside of market hours or I am not invested (anymore) I (execution-me) will have to call my manager (bossy-me), analyze and write down emergency plan for the specific situation, reason why I do it, how it aligns with the existing plan etc.
I wonder whether you had been able to test/quantify any “disaster strategy”?
Good points. I think… well, my understanding at least… of these types of events is that they are so rare and so extreme they basically defy analysis. Any any analysis we do would be extremely limited and unlikely to apply in the future. I think if you read Taleb on “black swans” that’s basically his point too.
Maybe the best lesson is that sh*t happens and we have to be prepared for sh*t to happen and not lose our own sh*t when it happens!
Hahaha, I’ll be working on it. Thanks.