The Many Paths of Uncertainty

As a trend follower, a key aspect of our approach lies in the way we approach risk. In fact we prefer to call ourselves risk managers as opposed to speculative traders.

We view risk as being far wider than what has been reflected by the historical record and treat risk as comprising two aspects.

The risk that resides in the historical record which we can see reflected in our backtests and the risk associated with the many possible paths that reside outside this single historic path which is absent from our backtests.

We understand that the possible risks that lie ahead of us in the many possible future paths, exceed the known risks that we have experienced from our limited past track record. We therefore adopt the premise that our worst drawdown is always ahead of us.

The following diagram provided by @waitnutwhy from Twitter Sphere illustrates this notion.

If we consider our history, there has been a single path taken to where we are today and a single risk sequence along that path…but from where we are today looking into the void of the future there is no such guiding sequential record. The future is one of many possible paths.

Now most traders focus on what history has revealed to us through their back-tests and adopt such principles that the future is influenced by events of the past, such as a prior equilibrium level, a prior support level, a past mean value or an historic intrinsic value. They therefore adopt a ‘convergent premise’ that price is likely to revert to that historic value….but as we can see in this braided possible view of future paths, a replication of the single historic path is exceedingly unlikely over the longer term. You see in a complex adaptive system, the only real guarantee that we have is that over an extended future, the far more likely proposition is that the future will be significantly different from the past.

This ubiquitous feature of a different future from the past is common to all complex adaptive systems where the agents that make up that complex system adapt and the system itself develops new efficiencies based on emergent structures that unfold through a systems evolution. The notion of system stationarity, or a repeated history, in the context of probabilities assigned across an almost infinite array of possible future paths, highlight the fruitlessness of trading systems that assume history will repeat or that capitalising on repeating patterns will lead to long term wealth.

By far the greatest degree of change to an unfolding system lies in the ‘improbable events’ associated with future paths that have never been experienced in the past. These ‘fat tailed events’ are the real game changers and where the fates of traders are determined by single ‘windfalls’ or ‘crushing defeats’.

As a diversified systematic trend follower, we treat this alternative array of possible risk sequences found in the infinite array of possible future paths very seriously. It is within these unforeseen events where our outliers reside that make our game so worth it, but to experience them, we have to survive the battering received from an almost infinite array of unfavourable events found in our future path.

In fact, we totally disregard the historical sequence of a particular market as being significant to our trading models. We do not undertake backtests to develop any opinion of expectation regarding the future, but rather we undertake backtests to ‘stress test’ our assumptions using a known historic data stream.

You see we treat all markets equally through our method and in our bet size allocation towards each market. Our method simply cuts losses short at all times, uses ATR based stop, trailing stop and position size calculation to normalize our approach to every market and we treat them all equally in terms of their possible risk contribution for the future.

What this actually means is that our method is configured to address a far greater possible array of future risk paths than alternative methods which simply configure their systems to what has been presented in the past.

Now many traders fall under the illusion that what history has demonstrated over their lifetimes is reflective of all possible risks….however the following excellent walk-through of the Dow Jones over the past 125 years demonstrates that the past 50 years or so of our memory is only a small sliver of a far greater representative sample of risk paths that have been delivered by our historical record alone.

So that video gives you a broader appreciation of the risks that lie in an extended scope of our single historic path.  So just imagine the virtually unlimited possibilities that the many paths of ‘uncertainty’ will bring for the future.

How confident are you now about the future longevity of your convergent trading models?

Trend Followers may be accused of having simple models….but where we shine is in our very serious treatment of risk which is found wanting with alternative approaches.

Trade well and prosper.