Probabilities and Black Swans

Grid Trading’s most appealing aspect has to be that you don’t need to know which direction the market will head, you can always make money. To be honest, anyone that tells you they know what the market will do is fooling themselves, and you.

What is the probability that the price will go up 1%? It’s the same as the probability of the price going down 1%! So it’s 50/50.

What about going up 2%? Well, it would have to go up 1%, and then go up 1% again, but it could go down again. You might be fooled into thinking that there are now 4 possible outcomes, which is right strictly according to probability. What if our target was 2% and our stop loss was 2%? Well, there is a 25% chance it hits our profit target, 25% chance it hits our stop loss, but a 50% chance of, well nothing. It went back to our open price.

If we are to hold on to our trade until it either hits the profit target or the stop loss, then we are not interested if the price goes back to the open price. So we have to wait until it either hits our stop loss or profit target… so that means we are back at 50/50 again. Actually, that was obvious from the start right?

Our hedged grid has an expectancy of zero. The chances of winning are the same as the chances of losing (of course we haven’t talked about swap rates). That means the chance of the price increasing by 50%, is the same as the price halving.

Wait… what?

That doesn’t seem right does it? Let’s see, GBPUSD is roughly 1.6 right now. We are saying that the chance of the price changing to 2.4 is the same as the chance of the price going to 0.8? Well, probability might say so, but real life would differ I think. I doubt very much the UK government would allow their currency to deflate to 0.8 of the greenback.

Does this mean it isn’t always 50/50? Maybe there is hope for technical analysis after all!

Now, let’s talk about swans.

Nassim Taleb, author of Fooled by Randomness, outlined a term known as the Black Swan. If you don’t know about the Black Swan, allow me educate you from my understanding (I haven’t read the book yet).

All over the world there are plenty of White Swans, I personally have seen them in the UK, Europe and Asia. So there used to be a saying used when describing impossible events… “Yeah that will happen when we find Swans are Black” … we have other sayings like that too, for example:  “When pigs fly”.

And then years later, British explorers went to Australia, specifically Western Australia, and to their surprise there was Black Swans. So suddenly, even the impossible was possible… which is Taleb’s point. These events that seem impossible sometimes do happen.

So this brings us to Taleb Distribution. Taleb Distribution, named after the above mentioned Nassim Taleb, is used to describe (as quoted from Wikipedia) “a returns profile that appears at times deceptively low-risk with steady returns, but experiences periodically catastrophic drawdowns.

So Grid Trading has a bit of a bad name out there. People associate it with scams, and it is easy to understand why.

Suppose I sell trading signals (http://www.signalstrading.net/content/signal-provider), or start a fund and get investors, where the strategy trades the grid and makes consistent good returns. However, I’m betting a lot more than 1-mini-lot to make more returns and it seems ever appealing and everyone jumps on board. Ultimately the market crash will come and since I’m over-leveraged, my fund goes bust, and you go bust (or only you go bust in the case of the signal provider).

However, you going bust is not my problem. I have already collected lots of subscription or account fees (the above signal service is $99 per month!) , and I disappear only to pop up under a new company name. This is covered under the Moral Hazard in the Taleb Distribution page above. So you can see why Grid Trading has a bad name.

Now, I believe and I have hopefully given you all sufficient proof that Grid Trading has huge potential to make massive draw-downs, but I also believe these draw-downs can be mitigated through appropriate position sizing, as I have shown.

I don’t believe the probability of the price going down 50% is the same as the price going up 50%, so I think there is some value in analyzing a currency’s range (as we did in the previous post) and making sure you can handle that range, and more!

So, we should plan for GBPUSD hitting 2.4 or 0.8 regardless. So far the only weapon we have against this is small position sizing. However, there must be some better way, and this will be my focus for the next coming weeks.

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