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Why do traders accept black swan risk?

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North Carolina
 
Trading Experience: Beginner
Platform: NinjaTrader, Tradestation
Favorite Futures: es
 
Posts: 644 since Nov 2011

Why do traders accept black swan risk?

Why do traders accept black swan risk? Or rather why do black swans exist when they neither benefit traders nor brokers? We can imagine that for short-term traders that black swan risk is not desired because the pay off is too low to develop a winning strategy around and yet the catastrophic risk is still significant over a long enough time. Also, black swan risk is not beneficial to the brokers who will need to try to collect from traders who won't have the money and thus put their own companies at risk of going into default. It seems if something was not desired by everyone then the markets could engineer the risk away.

The only answer I can think of is that the markets aren't really designed for short-term speculators but rather for large traders who need to hold positions for long periods of time and need to use the markets for hedging. And, they are also built for large liquidity providers who can profit from the spread.

In my crypto-currency thread, I speculate a frictionless binary options market could be developed which wouldn't require a spread or market maker but instead would be a parimutuel market. And if you look at the largest trading companies, they all want to be the market maker. They want to provide liquidity. That's very nice of them, right. Why do two "losing" traders need a middle man? The way it would work is that you bet up or down and you do not need to beat the 1% to 5% market maker spread because you get to bet on the true mid point. The only trade off is that your profits are a function of your relative advantage over the other traders. For example, if everyone bets up and the markets go up then everyone gets back their initial bet for a 0% loss and a 0% pay out. If on the other hand, say you bet up and another trader bets down then you get a 100% pay out (assuming they are equal sized bets). This would be a truly zero sum market -- which if actual markets are negative summed -- should be better for short term traders. Even if it wouldn't attract large traders, shouldn't such a market attract volume in the form of small traders because you would be able to bet with zero frictions? (There might be some sort of monthly fee for running the exchange/computers.)

I imagine it might work on a turn basis but more advanced methods might allow for more fluid natural trading. Anyway, one issue might be HFT traders trying to game it by submitting the order at the last second of the open bets period. However, I'm thinking this could be mitigated by using the mid point as the volume weighted average mid point of the bid/ask spread over the time and/or by introducing a slight premium for late bets. I'm assuming you could also do knock-outs, i.e. similar to stop and target, using similar principles.

I am also curious how such principles would work with backtesting. Because, in backtesting you can only test the price but not the ability of the other traders to predict the price. I think as long as you didn't add the tie breaker then backtesting would still be valid because you would be guaranteed to at least not lose money on your winning trades. Though, sure you could end up breaking even on your winning trades and still losing on your losing trades. Also, if you have a large edge then you might be better going to the market maker or liquidity provider because you would be guaranteed a full pay out. However, for short-term day traders who don't really have much of an edge seems like it would work better. The only other catch is that if the average short-term day trader is actually much better then the average market participant, i.e. large trader, then it might prove to be very difficult -- in that case though the parimutuel market would be a leading indicator of the futures market.

If you look at say futures markets, they are skewed to benefit the large trader, either the trader who will hold their position or the large liquidity provider who can sit on both sides of the bid/ask and profit from the spread. I am thinking that a parimutuel market would level the playing field because you do away with the middle man, i.e. liquidity provider. You could either pay a monthly fee to access the market which would pay the datafeed and might provide a seed (reward) value to encourage trading. The trades could either be sealed or open market. In the sealed scenario, you won't know what you can win until after you place your trades whereas in the open market scenario, the pay offs would change in real-time.

1. Sealed scenario. You have to trade in turns. Such as market higher or lower in X time. You have a certain amount of time to place your trades/bets. These are matched against others in the pool. The start value is a weighted moving average of the mid point of the bid/ask spread with possibly some some sort of efficient premium "give up" for late betting. There may or may not be a seed value or minimum win.
2. Continuous scenario. The pay out are updated in real-time. In this way, you can see the aggressor side or dominant side like in traditional order flow markets.

Parimutuel markets might, also, allow for purely algorithmic securities pricing with no need for traders. Shares would be made available for buying or selling based on rationing principle. While not good for those who like to trade, it also gets rid of the middle man and also any irrational pricing. The way it works is you create a programming defined contract which will set the price based on your algorithm. Buyers or sellers can enter at any given turn at the efficient price. More buyers or sellers cannot move the market. Instead, there is a rationing principle based on who gets in first and size. The price is thus guaranteed by the algorithmic pricing but there is no guarantee of liquidity. However, presumably if the programming is rational then there would be buyers and sellers.


Last edited by tpredictor; September 21st, 2017 at 02:52 PM.
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