Tail risk and last-minute equalizers

 

Tuesday this week was the middle son’s 13^th birthday, and the family went to watch our football team in an FA Cup replay. Up against a Premiership side, we weren’t particularly optimistic, and 2-0 down at half time, even less so.

But we scored with just 7 minutes to go … and in the final seconds of the game, at 94 minutes, we equalized.

It was thrilling stuff by any standards, but for my kids, watching your team get the equalizer in what was the final kick, with the goalie up in the box with the forwards, was the stuff of dreams.

What’re the chances of scoring the crucial goal in the dying moments of a game?

I don’t want to spoil the fun (so don’t tell my kids) … but the reality is that it’s not that uncommon. A surprising percentage of goals are scored in stoppage time.

It all comes down to fat tails.

Fat tails are the extreme, unlikely outcomes – the things we just didn’t think would happen – and that actually happen a lot more often than we think.

An understanding of tail risk, and fat tails in particular, can make a big (and very positive) difference in your approach to the markets, although it can make you more jaded as a football supporter.

What’s tail risk, and how does it affect you?

You’ve probably heard investors talking about ‘tail risk’ – these are the extreme outcomes. They’re the times when we bought Bitcoin just before it went meteoric … and the times we bought shares just as the company went bust …

To understand tail risk in our trading, imagine a trading strategy that buys or sells a trade at random (on the toss of a coin), with no stop level and no profit target. It then closes the trade 24 hours later, taking a profit or loss (wherever the market has taken them). And our trading strategy continues to do this, day in, day out, for years.

We might expect the distribution of our profits to look something like this (not taking into account trading costs) …

This bell-curve chart is what’s regarded as a ‘normal’ distribution.

But market returns tend not to show normal distribution, with extreme outcomes more likely than most investors realise. These extremes show themselves as ‘fat tails’ …

The fat tails mean that extremes (those big winners and big losers) are more likely.

This is actually fantastic news for trend traders, and is exactly how we can beat the markets

To turn that fat-tail distribution into a winning trading formula, we need to do just three things …

1. Let our profits run (so we can take advantage of the up-side fat tail)
2. Cut losses (so we can remove the down-side fat tail)
3. Repeat

It sounds ridiculously simple, but that’s all that’s required to move our trading into the shaded area on this distribution curve …

So how do we do this practically?

Let’s go back to that not-so-good trading strategy that bought or sold at random once a day. If we adapt that strategy so it has a trailing stop on it … we could instantly cut off the negative fat tail, and enjoy the benefits of the positive fat tail.

And that’s it …

A profitable trading strategy without even having to open up a candlestick chart!

Surely it can’t be that simple?

Well, here’s the thing …

We can’t just cut off the tail and not account for what happens to all those losing trades. They haven’t just disappeared!

The reality is that when we cut off the left-hand fat tail, we’re left with an unsightly bulge at our stop level.

Which is why the right-hand fat tail now has to work especially hard for us.

And two things will enable it to do that: trend following, and trailing stops that allow us to push our up-side further. Both of these will shift that bell curve into our favour, so we can win against that ‘bulge’ of small losses.

And here we get to the heart of trend trading …

… finding the balance between holding out for the big moves, while not taking more losses that we can cope with (both financially and psychologically) in the meantime. It’s navigating this balance that sees so many traders fall by the wayside.

The more aggressive you can be (i.e. the longer you can hold out for the bigger wins), the more money you can make. But aggressive trading takes deep pockets and nerves of steel. For ordinary mortals, a more pragmatic approach is better.

Yes, we need to let our profits run. But we also need to pocket some more modest winners along the way, to keep money in the coffers.

But, for me, the knowledge that I’m tapping into that right-hand fat-tail of profits keeps me going through the rough patches. Just as knowing that sometimes my team will score in the 94^th minute …

 

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