Learn to Profit from a Black Swan Event
Today I would like to explore three concepts in trading that many traders have never thought about. Fragility, robustness, and anti-fragility are concepts that describe a trader’s psychology, risk management, and method.
Here are some general definitions:
Fragility is a word used to describe something that is easily broken, shattered, or damaged. It means very delicate or brittle.
Robustness is a system’s ability to operate without failure under a variety of conditions. Being robust means a system can handle variability and remain effective through variously different environments.
Anti-Fragility is a concept where high-impact events or shocks can be beneficial to certain kinds of investment methodologies. It is a concept invented by professor, millionaire trader, bestselling author, and former hedge fund manager Nassim Nicholas Taleb. He invented the term “anti-fragility” because the existing words used to describe the opposite of “fragility,” such as “unbreakable” and “robustness,” were not really accurate. Anti-fragility goes beyond these concepts; it means that something does not merely withstand a shock but actually benefits from an outlying Black Swan event.
Fragile Traders are the new traders that usually do not make it a year. Their psychology is fragile; they do not make it through the learning curb because they expect to immediately make money in trading. Trading is like any other professional pursuit and takes time, professionals in every field spent years learning expertise and trading is no different. Fragile traders lack the mental strength and perseverance to stick with trading until they are successful. Fragile traders make decisions based on their pride, fear, and greed and this eventually breaks their accounts.
Their risk management is fragile; they risk a lot to make a little. Big position sizing leads to fragility because all it takes in one big adverse move to seriously damage an account.
A fragile trading methodology is one based purely on opinion that really has no edge. Even worse it is counter-trend where a trader thinks the logical thing to do is to short up trends and go long down trends instead of going with the flow. Shorting bull markets and catching falling knives is a very fragile trading methodology.
Robust Traders are usually trend following traders, but not always, there are many different types of robust trading methodologies that put the odds on their side.
Part of what makes traders successful and robust is that they do not put too much weight on any one trade. The most successful traders I know limit their total account risk on any one trade to 1%-2% of total trading capital. They carefully look at a market’s volatility and logical support levels to position size appropriately and set stop losses.
Their risk management principles makes every trade just one of the next 50-100 trades. This brings down the stress levels and turns down the volume on the emotions of fear and greed. They risk a little over and over again for the chance to make many times their risk.
A Robust Trader has completed the homework on their methodology, system, and principles. They understand why their system works and what their edge is. They keep the faith in their systems even during losing streaks because they understand the realities of different market environments. They know what kind of trader they are and they know what they believe so there is little internal dialogue of doubt and confusion, they just trade.
The robust systems that they use are generally trend trading systems so they can profit in both bull markets and bear markets. Trend traders need trends to make money and do not do well in choppy trendless markets and range bound markets. Their systems are robust because the trends do come back around eventually and in those trends they are very profitable and make up for the smaller losses in trendless markets.
The Anti-Fragile Trader is one putting on very small position sizes in low probability trades but shifting huge amounts of risk to the trader on the other side of their trade. The methodology of the anti-fragile trader is to bet on the eventual blow up of the traders making high risk trades for a small premium.
The favorite tool of the Anti-Fragile Trader is the out-of-the-money option contract. For pennies on the dollar they can control huge amounts of assets. While they expire worthless the vast majority of the time when a random Black Swan event hits the market effecting the option contract they can return thousands of percent on capital at risk and make up for all the past small losses.
The creator of the anti-fragile concept Nassim Nicholas Taleb traded long option strangles betting on both directions to capture any huge trend event up or down. A company being purchased and rocketing up or a disaster and a company stock sent crashing was hugely profitable for Taleb. He also bought option contracts on futures markets. The key is very tiny bets on these trades versus total account equity. Tiny losses and tremendous wins was what made the system eventually profitable.
The anti-fragile trader wins in volatile markets and random Black Swan events outside the bell curve of normal price movements. Taleb made a fortune in the Black Monday crash of 1987 and many other times over the past 25 years.
Anti-fragile could also describe the mentality of a successful trader. They grow stronger through losing trades by learning instead of quitting. Rough market environments do not break them; it educates them on what to do different in the future. A trader who is mentally anti-fragile has no doubt that they will be a successful trader and that only time separates them from their goal.
Now our question is where do we fit in and what do we want to be?
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