Black Swan and Trading Strategies : Protecting Ourselves Against Unknown Events

Certainly when you trade within any forex account you should know that the probability of a total account loss is always present despite any money management principles or account safe-guarding you might put into practice. There is always the possibility that something might happen which might make your stop loss, exit tactics and other money management guidelines useless as the market destroys your trading funds. This type of event where something so devastating happens that it puts your account at a wipe-out risk might be called a “black-swan” a term coined to refer to very rare events which are – although extremely improbable – possible. On today’s article I am going to talk to you about the robustness of trading systems against black swans, what we can do to protect our accounts against such events and what we cannot do.

In nature, the swan is generally known as a bird with white feather. However, during the 18th century people discovered a new kind of swan – a black swan – which had gone unrecorded for all previous history. This is why Nassim Nicholas Taleb decided to name his theory of improbable events the “black swan theory” dealing with the existence of events which were not either predictable – in their consequences, scope or effect – nor preventable in anyway. In his theory Taleb talks about events which have high impact in historical terms which mark dramatic “turns” in the way in which things had unraveled. For example, the birth and life of Jesus of Nazareth can be considered a black swan historic event, something that dramatically altered history thereafter which had an effect that couldn’t have been predicted before hand with a probability that cannot be accurately calculated (because of its rarity).

In trading of course, I will refer to “black swan events” from a slightly different perspective, not talking about historically important events – although they might obviously link – but about technical trading events which are bound to be extremely rare. The rarest of the possible events that could be damaging to forex traders – and the one we must concern ourselves the most with – is a large gap event.

When you enter a trading order on the market with a stop loss value, the order guarantees that the broker will get you out of the market on the next tick worse or equal to your stop loss which grants enough liquidity for you to get out. In regular market conditions – in a market as liquid as the foreign exchange – this means that you will almost always get out at the exact stop loss price or a value slightly below. However when the market gaps below your stop loss – like how it can happen during a weekend – you can get a loss which is worse than your stop loss since the next tick available lower than you stop loss is significantly below this value.

The largest gap I could find in forex trading during an analysis of the past 10 years on the 4 majors was of around 300 pips on the GBP/USD, corresponding to what appeared to be a very surprising NFP release. However if you have a system which trades at a 2% loss per trade with an 80 pip stop loss a 300 pip “worse than stoploss” gap would imply a loss of  9.5%, which is a large yet manageable loss for a single trade. In order to wipe your account, the gap would need to be about 10 times bigger or 3000 pips, implying a move from – for example – 1.5 to 1.8 on the exchange rate without any ticks in between.  Is this impossible ? Since this has never happened and we do not know what is needed in order for this to happen it becomes impossible to know either its probabilities or its causes, indeed a true “technical trading black swan”.

What can we do ? There is little we can do if such a scenario develops. However there are several safeguards we can take to minimize or potential losses from such a catastrophic turn of events. First of all, we should implement a safeguard against large gaps (which would mark very uncertain market conditions), therefore it becomes important to make systems halt trading if they ever detect a gap larger than, for example, 10 times the last 14 period ATR. Such a system halt would imply a total system stop, needing a manual restart for the systems to continue their trading.

The second safeguard we can implement is the use of a wide variety of low risk systems instead of a few high risk systems. Having more systems with less risk implies that only a fraction of them might be trading at any given time and the outcomes of their losses if they get caught in the “wrong side” is diminished. Another safeguard which is important is the implementation of strategies without a take profit which can help us “profit” from such a move while other strategies taking losses suffer. Such a hedge is NOT possible with strategies which use a TP because the take profit order implies the broker will fill your profit AT the TP level if the market moves above it, so if there is 1000 pip gap, you will be filled at your TP, NOT at the much more favorable gapped price. In the end it is good to have a few strategies that don’t use a TP in order to have an “open end” in which we can profit if a strategy catches the black swan event towards the “good side”.

As you see, we are then quite limited in our capabilities to protect ourselves from such improbable yet potentially destructive events. Having a safety feature to prevent trading after the black swan happens, having many systems with low risk and having systems that can potentially “follow the swan” are some of the things we can do to prevent a black swan effect from wreaking havoc into our trading. Can you have total protection against a black swan ? Can we guarantee that there won’t be such an event ? No. All we can do is prepare in whatever ways we can :o).

If you would like to learn more about my work and learn to develop your own likely profitable long term profitable strategies and design your own automated trading system portfolios please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach to automated trading in general . I hope you enjoyed this article ! :o)

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11 Responses to “Black Swan and Trading Strategies : Protecting Ourselves Against Unknown Events”

  1. Maurizio says:

    Hello Daniel, thank you for this very important article, as capital preservation is a main concern in Asirikuy philosopy. In order to reduce the risk, I’ve always preferred to run several systems together with little risk each, of course by keeping the possibility of opened drawdowns under control. My question is if you will plan to configure portfolios in the future with a better “black swan” protection, for example by adding some system without TP or by modify the current systems in order to stop working in case of big gaps. About systems that could stop working in this catastrophic scenario, I don’t understand how they could avoid it if they will stop working only after the gap has already happened.
    Thank you.
    Regards.
    Maurizio

    • admin says:

      Hello Maurizio,

      Thank you for your comment :o) It is important to know that since the nature of a black swan event or its probability is unknown you cannot avoid trading BEFORE the event, therefore if any system has any trades opened they WILL need to pay whatever exposure they have towards the market, however other systems that detect this gap can stop trading (not entering any new positions) in order to avoid the future abnormal price action that would certainly follow. You need to understand here that we cannot totally avoid exposure to a black swan since its very nature implies we cannot, all we can do is react to the first signs of it happening (stop opening any new positions), take whatever we can from positive movements (systems that follow through like Ayotl and Quimichi) and take the exposure from systems that are badly positioned. I hope this answers your inquiry :o) Thanks again for your comment,

      Best Regards,

      Daniel

  2. Al says:

    Hi Daniel,
    Another black swan event that comes to mind is a very long series of losses, where our SL is hit over and over again. This, by the way, reminds me of another post of yours, where you discussed the time to stop using a system and whether the WC (double the largest historical DD) is the only thing that can tell us to stop using that system.

    The idea is that we should set a number of WC SL per system, meaning double the longest losses sequence length in our 11 years backtesting results, which may tell us earlier to stop using this system before we get to the WC scenario.

    I appreciate your feedback,
    Thanks!

    • admin says:

      Hi Al,

      Thank you for your comment :o) I think that you are misunderstanding the concept of a black swan event. A black swan is an event which has never happened for which the probability of it happening CANNOT be calculated. Since we can perfectly calculate the probability of having a string of X consecutive losses this is NOT a black swan event. Either way we have several criteria – like Monte Carlo simulations – which help us know the maximum expected number of consecutive losses according to our system’s long term statistical characteristics (allowing us to stop trading the system/portfolio if this number is reached). Other criteria such as the Clopper-Pearson boundaries will also be used in the near-future for this purpose. I hope this answers your inquiry :o) Thank you very much again for your comment,

      Best Regards,

      Daniel

      • Al says:

        Hi Daniel,
        Thanks for your answer. However, I was not referring to a situation which its probability can be calculated; Monte carlo simulation relies on the probability variables we supply to it; What if the market has changed so much that the probability we supply our simulators is now different? For example, could it be that the market will at some point in the future become so stable that some of Asirikuy’s trend following systems will start resulting in many losses for exceptionally longer period of times? I’m not referring to a mere probability thing, but to a situation where the current design needs revisited because the system fails to adjust itself for some reason. And if we say this can’t happen, wouldn’t that be like saying there’s no such thing as a black swan?
        Thans again for your feedback

        • admin says:

          Hi Al,

          Thank you for your reply :o) Again I think that you do not understand the black swan definition very well. A Black swan is an event that has NEVER happened before whose probability CANNOT be calculated. In the case of Asirikuy systems we have clear Monte Carlo devised targets which tell us “if your system has X consecutive losses then you should no longer trade it since it no longer holds true to its long term characteristics”. If the market changes to the point where a system goes below its Monte Carlo worst case consecutive losing trade threshold then you STOP trading it, it’s that simple. We know that if the a system has X consecutive losses the probability of the system no longer being profitable is very high so we can easily stop trading it. Obviously very large numbers of consecutive losses can happen but we know EXACTLY how many are expectable and how many are away from our system’s expected behavior, therefore allowing us to stop trading the systems as I mentioned above if a certain threshold is reached.

          A black swan is – on the other hand – an event which does not follow ANY such planning or predictability such as a 3000 pip gap or a candle with a 5000 pip shadow, such things have never happened and therefore their probability cannot be calculated and our systems cannot do anything to defend themselves from them before they actually happen. I hope this clears it up :o) Thanks again for your comments,

          Best Regards,

          Daniel

  3. Rimas says:

    In order to lessen the risk we could use only for axample 30 persent of the investing money in the account dedicated for particular strategy or portfolio. So we would not lose all the account in a black swan event. But on the othe side we would need to risk more to reflect the real trading size, we would trade on the full account. I am not sure now if managing risk in this way will not complicate the corect risk per trade taking when the balance increase or decrease, but if to use the initial balance option it should work I gess. The aditional funds could be in the other account of the same broker dedicated for such events and not used for trading at the same time. Sure it doesn`t mean it requires additional capital than we would trade as usual.

    • admin says:

      Hi Rimas,

      Thank you for your comment :o) Your suggestion would NOT work as black swan events put the account at risk whenever you have an open position INDEPENDENT of the position size. Bear in mind that the internal balance mechanism does NOT protect you against losses beyond the chosen capital amount as when a black swan event happens you will be UNABLE to exit at your SL which means that no matter what your position size is or how you determined it your account WILL be at risk. There is no effective way to protect against large unfavorable gaps in the market when positions are open simply because there will be no buyers/sellers to be counterparts to your position at levels within the gap. Black swans are an INEVITABLE part of Forex trading risk, irrespective of any lot size adjustment arrangements you make, remember that this is a matter of being UNABLE to exit trades ! Thanks again for posting,

      Best Regards,

      Daniel

  4. Rimas says:

    What I mean that, let`s say we have a gap that goes a thousand pips and we would lose 50 persent of the account. If we had a smaller account where we trade at higher risk to reflect the acctual investing money then in case of that gap we would blow the account but it would be only 30 persent of the all investing money.Then we just deposit the additional funds dedicated for this account and we trade on. If it make sence.

    • admin says:

      Hi Rimas,

      Thank you for your reply :o) In the end it makes the same practical effect as trading on the original account. Bear in mind that this does NOT protect you against gaps as in Forex you can OWE money to the broker if the gap closes with a loss higher than 100% of your deposit. There is NO such thing as a margin call if there is no price at which to close with a 100% loss. If there was a two thousand pip gap you could owe money to your Forex broker because the margin close level could be at for example -20% (lost all your deposit and owe 20% to the broker). Broker contracts clearly specify that margin call protection is subject to the ability to liquidate positions. I hope this clears it up :o)

      Best Regards,

      Daniel

  5. Rimas says:

    I mean if we have a gap, when we have an open trade and the gap goes against the trade.

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