It’s nice to be back in the saddle after a relaxing two-week break in Kerela, India – a great country with friendly people.

I can’t report on any systems I’ve looked at over the past fortnight (what a week to miss!), but I’d like to share with you some interesting holiday reading.

I’m a voracious reader on holiday and enjoy catching up on my reading list by the pool or on the beach. I actually did quite a lot of reading while travelling around – often because I didn’t dare look up from my book while travelling in a car or bus.

The Indian method of overtaking seems to involve little more than honking your horn to warn the vehicle in front. You then pull out and over take. This rule applies on blind bends on mountain ridges and jam packed cities with oncoming cars/ busses/ auto rickshaws/ cows.

The Kerelan food didn’t get me, but the driving nearly did! We were on our way to the wildlife sanctuary of Periyar and the bus driver was flinging us around like we were on a rally. Unfortunately, I had a seat next to the window so I could see how close we were to the sheer drop each time he overtook the car in front on a blind bend. Not being blessed with Mrs Market Maven’s ability to fall asleep on a roller coaster, I distracted myself by reading the whole way with the ipod on full blast.

I only looked up when there was a particularly load blast of the horn.

Thankfully, I had some very good books to get through. Books that have made me come back and look at the markets differently than I did before (after kissing the ground at the end of very bus journey). Do not be fooled by randomness – read these books and see things for what they are.

Fooled by randomness – how the books of Nassim Taleb can aid your trading

For a while I’ve been wanting to read two books by Nassim Taleb, a mathematician, philosopher and above all, trader. He’s written two acclaimed books called Fooled by Randomness – The Hidden Role of Chance in Life and the Markets and Black Swans – The Impact of the Highly Improbable. What makes these books so interesting is that he seems to have predicted the current credit crisis. Taleb’s main argument is that human beings are pretty stupid when it comes to understanding the role of chance in our lives and most importantly in trading.

We see patterns everywhere because we are genetically programmed to. It means that we’re highly likely to fall into the trap of saying: “Well it’s done this in the past, it must mean it’s likely to continue.”

We tend to look for explanations for everything when quite often things just happen by chance. We also tend to overestimate causality, for example, we see a face in the clouds instead of understanding that there are just random clouds that appear to our eyes as a face.

One of the biggest breakthroughs I made in my trading was when I realised that financial markets are mostly random. Instead of trying to predict every move exactly and castigating myself if it didn’t go my way, I simply let the market do what it’s going to do and manage the trade accordingly.

It felt like a huge weight was lifted off my shoulders. Instead of trying to predict the unpredictable, I focused on setting up low risk trades that stood a good chance of making a decent profit. Once the trade is entered, it’s over to lady luck because anything can happen. You cannot predict the market every time and nothing works all the time, but there are repeatable patterns that present themselves time and time again. Each instance is unique, but with sensible money management you can gain a profitable edge over the long term. This differs slightly from what Taleb is saying, but I found this perspective useful.

Beware the black swan!

A black swan is an outlier, an event that lies beyond the realm of normal expectations. Most people expect all swans to be white because that’s what their experience tells them: a black swan is by definition a surprise. Nevertheless, people tend to concoct explanations for them after the fact, which makes them appear more predictable, and less random, than they are. Black swans can have extreme effects: just a few explain almost everything, from the success of some ideas and religions to events in our personal lives.

The stock market crash of 1987 was unexpected, up to that point markets had never fallen that far in a single day. People made trades based on the previous worst one-day fall on the assumption that this would never be exceeded. It was and many people lost their shirt.

Don’t be a turkey

Taleb provides a great example of how a black swan might play out. A turkey’s feeling of safety could be measured on a graph starting at a low level at birth and gradually rising as he grows in his confidence that no-one is trying to kill him. On a graph, his confidence levels would look like a steadily increasing stock price then come December, these confidence levels drop like a stone down to 0. There were no indications from his past experiences for him to expect his Christmas culling. To him, it was completely unexpected, a Black Swan.

According to Taleb, most traders are like Turkeys. They make their trades based on their past performance and increase their risk because they experience success. Then one day they hit September 11th/ The Russian bonds defaulting/ Asian Tiger economies crashing/ 1987/ The dot com bubble busting and of course… The credit crunch. Because traders at investment banks are paid on annual performance, he who pulls in the most that year will get all the glory and if he’s a prop trader, he will be given a great allocation of the banks resources. In the lead up to the credit crunch fixed income traders were making a killing from trading mortgage backed securities. The more money they made, the bigger the bonuses they got and the more money the bank gave them to trade with. The problem was that they were acting like turkeys, blind to the massive risk of the credit crunch because they could not foresee the potential perfect storm that was brewing. It was unexpected, it was their black swan. These fixed income traders were making small, regular gains while believing that they were risking very little. In fact they were “picking up pennies in front of a steamroller”.

I won’t go into this too much, but traders made the mistake of assuming that financial markets are ordered in their randomness like a coin flip or the distribution of height in the general population.

According to Taleb, you’re not going to get a massive outlier in the average height of the world’s population. People’s heights will be equally distributed above and below the average height. The highest person in the world is around 8 foot which is tall but for the financial markets to be ordered like height as many mathematicians assume, it would mean that extreme crashes and conditions are equally not too far from the average.

The trouble is that the extreme events in financial markets are the equivalent of finding someone who is 500ft. You don’t get black swans in height, you do in the financial markets.

The credit crunch happened because traders had over extended themselves based on the belief that markets would continue as they had. In fact years of profits were wiped out in days.

How to trade using black swans

Taleb isn’t saying that you can cannot use the past to create potentially profitable trading set ups. What he is saying is not to base your risk management on the assumption that the worst case or a black swan will not happen, because if it does, your entire trading account and possibly more could be wiped out. You cannot predict black swans, that is the point of them. Take the Newcastle United Chairman Mike Ashley. He’s reported to have lost over £100M spread betting that HBOS would be up in 2008. It’s not quite a black swan that HBOS was hit with the false rumours that it was going down the North Rock route, but it’s not far off. The trade might have been good at the time of placing it, but to keep it running was just plain stupid. I thoroughly recommend reading both of Taleb’s book and would start with his more readable ‘Fooled by randomness’. ‘Black Swans’, the second book can be a little heavy at times as Taleb shows off hisintellectual biceps. He’s opinionated and up his own backside a lot of the time, but in some ways, this makes the books all the more entertaining.

Highly recommended reading!

My trades

No trades while I was away. I know some people who like to keep abreast of things with streaming quotes on their mobiles etc. I prefer to either be 100% focused when trading and 100% out of the market when on holiday, otherwise I can never switch off. Just my personal preference.

This week’s hot trading buttons

After an extended break, the FTSE has bounced back after a great session on Wall Street yesterday. Even the beleaguered US house builders enjoyed support. Leading the charge were technology stocks, with the Nasdaq 100 up over 3.5% and Google firing up over 6%. The big question now is whether Bernanke’s emergency measures have stemmed the flow. Judging by the trading around the bank holiday weekend, the market seems to think so. Last Monday could prove to be an exhaustion low in the intermediate term. 2008 has been typified by unexpected events, but the biggest surprise may still yet to come. With every man and his dog expecting a US recession, could a blinding rally turn out to be a black swan? I wouldn’t bet my house on it, but maybe, just maybe things could turn out to be as bad as expected.

The Smart Money/ Dumb Money spread over at is now at extreme levels with the dumb money massively short and the smart money long. The indictor hasn’t had great time of it of late, but Jason Goepfert has moved his bullishness to 3 out of 4 on a 1-3 month basis.

Otherwise it’s a pretty quiet week ahead, but you never know what bear trap might be hiding round the corner.

I’ll be looking to ease myself back into the markets this week. I hope you’re having a good time of it. Happy trading!

Trading wisdom

1) Before you put your capital at risk, have a well-formed trade idea;

2) When your idea pays you out quickly, take some profits;

3) Don’t get caught up in individual trades; focus on profitability over a series of trades and days.”

Brett Steenbarger