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Why do traders accept black swan risk?

  #5 (permalink)

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

@Matt

There is a logic to all the ideas I have tried to lay out. First, I have suggested that taking black swan risk is not in the interest in of short term traders. Next, I have suggested that liquidity providers are, also, not needed as one trades on shorter and shorter time frames and, in fact, the liquidity provider or the auction-market system represents a hurdle to overcome. If two short term traders trade against each other, with equal skill, in current system they will both lose. The only way the short term trader can win is to take the other side of a long term trader or trader with less skill. However, in a frictionless system without liquidity providers two short term traders of equal skill could break even against each other.

However, I think the following idea will make it clear as to why traders accept black swan risk: because long term traders need to take the risk because their primary profits are not a function of trading skill. Instead, longer term traders profits are a function of valuation.

In order to understand, let's imagine a business is selling 10 widgets at $10 a piece or has an income of $100. And for simplicity, let's just say their stock valuation is the direct function of this or $100. Now let's say all of a sudden they find a new source of customers in a new market and they are selling 20 widgets at $10 a piece. Their stock will reflect a valuation of $200. However, it never needs to trade at every price in between and importantly the money flow does not need to equal the market valuation. In fact, as soon as this information comes out, any holder will not want to sell for less then $200. So, the stock price will move very rapidly to $200. If the market is efficient very little money will be able to flow into the market from $100 to $200 price. And, that's also why you will see the market make jumps on low volume because every price is an opportunity and is a limited buy. It is just like if you own a house in an appreciating market, you don't need to sale it for the valuation of your house to change.

The markets can be seen as a risk transference mechanism with preference given to liquidity providers and structural advantage to long term traders.

But, the short term speculator doesn't really need to take the risk of market valuation changes because they will probably not be very predictable. Instead the short term speculator is basically trading other traders. They are basically taking the black swan risk to advantage long term traders who use market mechanisms primarily for hedging purposes. It is basically to pay to get access to the primary markets which are most efficient and/or to take the other side of long term traders. However, unlike HFT liquidity providers, retail traders have select disadvantage which is why I suggest a new market structure that is frictionless.

The question regarding the backtesting is say today that if you go on a short enough time frame today, you could develop a winning strategy but one that wouldn't be profitable after commissions and spread. In the new model I conjecture which allows traders to trade without any intermediaries, you can now know that you can trade without any spread and you won't lose money on your winning trades but you cannot ascertain how much you will make because it is a function of your relative advantage of whoever else is in the market trading against you. Also, you cannot be certain that the strategy overall would be profitable even though you know wouldn't lose on your historically winning trades.

Long story short: Markets can revalue without need for traders to make trades which is where the black swan risk comes from. And, most traders take black swan risk because the instruments that traders trade favor accurate tracking over limiting black swan risk. Secondary markets that can limit such risk have higher spreads and/or other hurdles today. The market mechanism I suggest would not have such deficiencies, although it would have unique new deficiencies, and would still probably not attract the larger longer term traders who trade the largest size.

Update:
I would point out something else. Imagine you live in a desirable neighborhood and all of the houses have appreciated well. Here is what is worth understanding: if everyone sold their house then none of the houses would fetch the high valuations. The high valuations are based on a small percentage of houses coming onto market.

Also, I would point out the liquidity provider are not really the adversary. It is the system that prevents two traders for trading without any frictions which is purely engineered to benefit the large liquidity provider and their large long term counter party. The large trader is okay with paying the spread because they have a higher profit factor. However, if someone wants to trade super frequently then they can't overcome the spread but they, also, aren't on a level playing field because the liquidity provider will stack the book. More over, they expose themselves to black swan risk because assuming the profit target will always be filled but the stop loss can be blown. And, assuming black swan risk is a type of instant market movement expressed in efficiency then such movements are more likely to become more frequent. In a perfectly efficient market, you will have the market flat line and then jump instantly to the next level.

Some exchanges have tried to engineer some of the risk away by introducing binary options or other options. However, these introduce tracking error. But also they will have a market maker or a liquidity provider and they will give them an additional spread over the futures market so they will quote the market. So, this makes it even more difficult to profit. But, as I have shown, this is not required as traders can trade directly among themselves once they are willing to accept variable payoff. In such a market, the best trader is more likely to be able to make a profit even if it the size of that profit can't be guaranteed.

I would point out something else too. In the traditional narrative, the liquidity provider is taking risk by providing liquidity. But, wait a second if you take say the ES futures and you have buyers and sellers transacting shouldn't they be able to transact at the midpoint between the spread? Why couldn't you have an order type that says hey match me in the middle. Think about it if 1,000 trades go off then that's 1,000 times the liquidity provider gets to capture the spread. That's 1,000 times both the buyers and sellers were disadvantaged by the spread.

So, what I'm arguing against is basically the futures exchanges is that they somewhat disadvantage the small speculator esp the small speculator who wants to predict the market and trade very actively. Because, the small speculator can't keep enough orders out to capture the spread and is always at the back of the book. Also, the spread prevents the trader from taking the fair zero sum bet. And you notice these liquidity providers want to quote more and more markets because they have the HFT infrastructure to make guaranteed profits.

Hopefully this will wake up the small speculator and/or secondary exchanges to consider offering zero friction trading products.. such as binaries facilitated by parimutuel pool microstructure.

Let's take a look again, at why traders take black swan risk because markets are priced or rather move not based on exchange of dollars but based on rational market valuation. Futures products provide some of the best tracking and lowest fees but still have spreads that disadvantage the small speculator who has a small holding time and can't obtain good book position. Secondary products as exist today have tracking error but also higher fees because they incentivize either the market maker/dealer or liquidity provider to capture fees from trading. The solution is for an exchange to recognize the value in frictionless trading for the active small trader and create this new structure.

Update:

From a post in another thread I made, "
As for the spread, absolutely it is set to disadvantage small speculators who could be transacting at the mid point for friction free trading. It benefits the large liquidity provider (or market maker) who can profit from the amount of volume transacted to offset the jump risk of losses. It benefits the large trader who will hold for longer periods of time and where the spread is a minimal cost of doing business. But, the small day trader who doesn't have HFT advantage to pull orders and doesn't have size advantage to obtain top of book nor the account size to hold for longer periods of time, it is actually a big disadvantage. Obviously it is a game where two great traders can be dimed to death by the middle man under the guise of efficient markets and that is also why markets can be difficult. I suggested in my other thread a way that frictionless trading could take place by using the midpoint and matching whatever orders come in.


I am not the only to realize this. I believe it was Michael Harris from Price Action Lab who did a theoretical study and shown that the spread in say the ES makes it more difficult to profit under theoretical conditions then say the spread in the SPY, which is smaller."

Question then why do small traders, like myself, gravitate the trading futures? The answer is that there doesn't exist a better available option.

Don't get me wrong: I love futures. But, that is just because a superior instrument doesn't exist. NADEX does provide an interesting alternative: however, you have even more frictions. But, here I have already layed out the mechanism for friction free trading.

The perfect trading instrument will be highly granular (small contracts), low frictions or no spreads (direct to direct trade), high liquidity, high leverage, and high tracking.

Stocks have high granularity, low spreads, moderate to high liquidity and low leverage.

Futures have low granularity (large contracts), large spreads, high liquidity, high leverage, and high tracking.

Binary options have high granularity, higher frictions, and lower liquidity.

Parimutuel pool trading which can be binaries or knockouts or other futures like instruments can be designed to have high granularity (small contracts), near zero frictions, high leverage, moderate tracking, and modest liquidity (but should grow once traders understand the benefits).

Michael Harris' simulation http://www.priceactionlab.com/Blog/2015/04/the-perils-of-day-and-position-tradin...-one-future-day-trading/


Last edited by tpredictor; September 22nd, 2017 at 05:15 PM.
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