A CHRISTMAS WEEK LESSON IN “TAIL RISK”

 

“If you don’t know what “tail risk” is in trading, you will soon find out!”

The new “Scalper’s Algorithm” for the less volatile pairs EURUSD, USDCAD, and when it’s not “nuts” cuz of Cable, EURGBP, has posted over in the “Download Links” section, in the right-hand column, and is available for online viewing [any browser or device OS] and/or download to your desktop, laptop, tablet, or phone [PDF]. You need not be a PAMM client, simply a reader who has an interest in better trading and making money. In other words, it’s free.

I think it would benefit everybody if I started at the beginning, and actually defined “tail risk”, from a probability standpoint. While there are all kinds of specialized distribution curves that address specific scientific and business problems and/or application needs, for our purposes, using the “normalized” bell curve [normal distribution] will be just fine. Directly below, the “bell curve.

 

All of the information in the “Summary Volatility Table” [see “Download Links”] for “The Magnificent Seven” FX pairs … all that summary data, either for weekly or 8-hour period [08:00 – 16:00], is data that is right at the top, smack dab in the middle of the bell curve … from there, we can determine our various “tail risk” scenarios, thus hoping to avoid them. Make no mistake, if you can either break even or make some money [any amount] from “tail risk” day’s, you will make millions trading, and simply a cursory glance at the new manual will prove my point, cuz the other types of days “bring home the bacon”.

There are 4 types of “tail risk”, that as traders, we have to be aware of and learn to deal with on a continuing basis; “tail risk” tends to cluster, and then may not show up for years or decades, until once again you hit 3 or 5 days in a row. There simply is no way of knowing when it shows up, so the only effective means of dealing with it, is to learn as much as you can about side-stepping it when appropriate, or even making some money off of it. The other types of days take care of themselves. Besides, what sense does it make to make good money on all other days, and then give it back “in spades” on a “doji” or “Flying Wedge of Death” kind of small range day? Most months, either in USDCAD or EURUSD, you’ll probably get “tail risk” 1 or 2 days out of the 20 trading days for the month.

The first 2 types of “tail risk”, most of you are familiar; 1) ‘bat guano” nuts daily ranges and very high intraday volatility, and 2) the other side of the “bell curve”, where it’s “Rip Van Winkle” in sleepy-time mode. For all 7 of the markets I’m tracking, it’s easy for you to know, at any time or any day, where you’re at in one of these markets cuz of the “Summary Volatility Table”. For example, in EURUSD, I know from the data, that the average, most active part of the trading day [08:00 – 16:00] will see an average range of approximately 57 PIPS, and a median range of approximately 46 PIPS; what does this mean? Well, assume it’s 10:00 server time, and doing some quick math, the range since 08:00 is 85 PIPS … that’s way above the norm, and it means there is a high probability it could be a very big range day. On the other hand, it’s 15:30 server time, and the range since 08:00 is 27 PIPS … now, you’re on the other side of the “bell curve”, and the market is “dead”; why take a position with a half hour to go and nothing is happening? Do any of us get paid for simply making a trade? No, so why do it?

The third type of “tail risk”, is “gap spike risk” against your position … how high or low is the “gap spike risk”, assuming no big reports or news, and if stops are hit off, what kind of risk are you assuming that you don’t know about? And herein lies the problem with the gold market, as Central Bankers have made it a permanent systemic risk with the “Rally Protection Team” that “monkey hammers” gold consistently day-in and day-out, and why volumes in gold futures are significantly lower than in 2011. Currently, this type of risk “infects” GBPUSD, and by proxy EURGBP, and all the other GBP crosses, cuz nobody knows when idiotic “Brexit” rumors will sweep these markets and be the catalyst for sizeable PIP moves in milliseconds … and good luck making back the 70+ PIPS you lost during the rest of the day or remaining part of the week. And it’s all due to a trader’s lack of understanding where his risks lie.

Fortunately, in EURUSD, our “tail risk” in this third category of “gap spike risk”, allowing for no news or reports, is excellent. Traders always need to be aware of “situational risk”, and knowing where support/resistance is on the 4HR, Daily, & Weekly candlestick charts, and therefore where the buy/sell stops are most likely to be found. If you don’t know that EURUSD has resistance @1.20, and that resistance price area has been tested and rejected over the last 6 months numerous times, you only have yourself to blame if you get short @ 1.19970, and with a buy stop @ 1.20070, thinking you’re risking 10 PIPS, the market hits your stop and you get filled @ 1.20455 … “thanks, have a nice day”!

The fourth type of “tail risk” is much more subtle, and very few traders think of it, but it is very real … when I get to today’s trading a little later, you’ll see, that this fourth type hit us today in trading EURUSD.

There are always “non-computable” problems in trading, where no matter how many lines of computer code you have, or math Ph.D.’s on the payroll working 24/7, that aren’t solvable … and the reason they aren’t solvable is cuz we deal in probability wave functions that come and go at the drop of a hat, and every attempt to corral a specific behavior pattern of a market, and then code it, the market changes and foils you … in essence, no matter what your algorithm, or trading model is if you will, all attempts at coding specific price information into it, will only create another probability wave function where there was none before. “The deeper you go down the rabbit hole, the more wave functions you create, and while some will work, others will not, and the Queen of Hearts stands ready to be your judge, jury, & executioner”!

There are inherent limitations of the MT4; 1) we deal in milliseconds, the banks deal in nanoseconds [Pony Express compared to the telephone], 2) our time frames are pre-defined and not programmable, and 3) the visual information on the screen most certainly has slight error factored into it, simply so we can see the damn thing!

There is no better way to illustrate this than thinking about the proliferation of “EA’s” [Expert Advisors] as the “road to riches”, when in fact they get eaten alive by the LP’s. They place their algorithm on the banks computer system … that right there invites trouble, cuz how long do you think the bank is gonna let an EA “pick them off” 300 times a day for a PIP, before they get wise and introduce slippage and/or other forms of monetary destruction? Once the LP bank figures out the “system”, a nanosecond before the “system” goes to buy 1 million stuff, the bid goes up 1 PIP … any guess where the EA gets filled?

The second big problem, is that computers only do what they are told … so, if you tell it to “take a profit” 20 PIPS from your fill, and it goes 19.9 before retreating back to your entry point, what are you gonna do? Well, I’ll tell you … you’ll change it to 19.5 PIPS from entry … next trade it goes 19.3 … you change it to 18 … next trade it goes to 17.7 … by the end of the first month, you’re down to “just get me the hell out with a $1.95 in profit, OK”?

So, any algorithm has inherent limitations, where there will be times where it is “right on the edge” … a fraction here or fraction there, makes the difference in doing or initiating a trade. Today, the first 5 hours 45 minutes [from 08:00] doesn’t even see a 20 PIP range in EURUSD… and then BOOM! … off we go Plum line over Yellow Line for the next 104 minutes and 50 PIPS … no buy signals cuz plum never went under yellow … now, there were 4 instances on the way up, where the Plum line 5 EMA LOW was right on top of the Yellow line 9 EMA LOW; a PIP or two move lower in an M1, would more than likely have given a buy signal … point is IT DIDN’T, and that’s “tail risk” that all of us face no matter how we trade. Granted, it didn’t produce an actual loss, but it was an opportunity cost.

Now, my point in discussing this, is that many traders, when the fourth type “hits”, will immediately start “tinkering” with whatever model they use … problem is, they don’t recognize that just because you might be able to eliminate some losses, how much profit have you given away by doing that? Remember, you don’t get ANYTHING for free from trading!

To recap, type 1 “tail risk” is hyper-volatility; you need to recognize whether you need to either 1) find another market, or 2) cut your trade size and allow for bigger losses. For me, I find another market. Type 2 “tail risk” is a “dead market” … at least 30 % lower than the median for the market … simply accept the conditions and lower your profit objective. Type 3 “tail risk” is “gap price risk” … GBPUSD, and all of its crosses are currently being held “hostage” by the insanity of “Brexit” rumors … best thing to do, unless you like quick, large losses, is to skip it and find “greener pastures”. Type 4 “tail risk” is inherent in all algorithms or models you use to trade … there is no way to eliminate this; simply understand the limitations of your algorithm and know what conditions in the market most often lead to losses.

When it comes to the “Scalper’s Algorithm” for EURUSD & USDCAD, this would be the small “doji” candlestick on the daily chart … it doesn’t “guarantee” losses, only that there is a higher probability on these types of days than others. The example in the manual, from 11/21/2017 saw 7 winners and 6 losers and was up PIPS. However, if certain conditions show up [which they eventually will at some point], the algorithms limitations will lead to a loss for the day, unless you know how to defeat the “doji” day. More on this in future blog posts.

Turning to today’s market, like I said before, almost 6 hours in and it’s a total “sleepfest” … 20 PIPS of up then down, rinse repeat… made one trade, it went nowhere, and the profit was meager; wasn’t thrilled with the entry price [no big deal, but off by 3/10^th’s of a PIP] but got right on the bid price on liquidation] … and then BOOM! … 104 straight minutes of plum over yellow and market goes up 50 PIPS … 4 times price came very close to giving a buy signal, but didn’t do it … Oy! And now, 26 minutes after 16:00, and the end of the trading day unless something is going on with new highs or lows, I finally get a buy signal … the first since 14:06, and I’m gonna get long? … Eh no. Cuz what I know, is that once 16:00 comes, unless there is news, Europe closes and New York becomes a graveyard … what am I gonna do with a position that AT BEST goes nowhere, and at worst starts leaking water giving me a loss, that is gonna be almost impossible to make back cuz everybody else on the planet is doing something else in the New York afternoon? And of course, that’s why I didn’t take it.

I’m a little surprised, given the euphoria in the U.S. equity market, that the U.S. Dollar started to weaken about 90 minutes from the open of the NYSE … and then from its high, EURUSD “Thelma & Louise-d” down 30+ PIPS in half an hour or so. If stocks are rallying hard, shouldn’t the U.S. Dollar be stronger? Second thing is the “Chuckleheads” in Asia bid EURUSD up again late in the Asian session; usually these clowns are wrong, but not today. I still look for 1.17000 level in EURUSD to be tested, probably before year end.

So, we’re in “Christmas Week”, and then New Year’s Week; the good news is that both Holidays come on Monday … that gives us the least disruption in terms of markets. Don’t assume that this week and next have to be quiet; many years they have been quite volatile, with year-end capital flows grabbing the headlines as we head towards the end of 2017. You can’t simply assume that ranges will be small.

While “tail risk” cost us opportunity today, the algorithm did a great job of keeping any trader following it, out of trouble, and those who actually captured the move starting at 14:06, there were a number of valid liquidation points, and it all pointed towards profit. As I said earlier, on “tail risk” days, anytime you can walk away up money, it’s a total victory, cuz the other days are “slam dunks”. And just before I post, EURUSD dumps another 30 PIPs, now under the 50% retracement line for the day; “if this keeps up, won’t tomorrow be interesting”? Onward & Upward!!

PAMM spreadsheet directly below … until tomorrow!

 

Have a great day everybody!!

-vegas

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