A Divergent Traders Perspective on Risk

As speculators, we tend to pay scant regard to risk as our myopic focus is centred on the notion of ‘reward’ which we couch in terms of predictability. ‘Reward’ being those favorable predictable outcomes with ‘risk’ (an afterthought) being those unfavourable possible outcomes in this restricted definition of what is predictable.

But risk is a far wider concept that comprises all possible paths to outcomes comprising  all favorable and unfavourable predicted outcomes including all possible outcomes that are not predicted.

Given this myopic focus on predictability, many fail to include both the favourable and unfavourable risks associated with the unpredictable which is where the divergent trader specialises. This is where we can draw a distinction between the viewpoint of a speculator as an informed gambler and the viewpoint of a speculator as a risk manager. The divergent trader is a lurking bottom dwelling risk manager that defends their adverse risk exposure and is rewarded by predating on the carnage associated with informed prediction.

The reason for the former restricted viewpoint of ‘predictable’ risk and reward is attributed to the way we as humans like to treat a future system state. We like to think that we have a solid grip on cause and effect and are rewarded by predicting future outcomes with fidelity which certainly has been reinforced by Newton and the Clockwork universe, the simplicity associated with reductionism and the ensuing swathe of studies in finance associated with the notion of the ‘rational investor’ and the notion of markets imbued with perfect information. Now these former attributes have their place in simple systems in controlled conditions where non-linearity has little to say, but in the complex systems of reality, it is the ‘unpredictable’ fat tail that leads to outsized favorable  and unfavorable outcome.

The divergent trader views risk differently. The risk universe is far greater and the concept of reward is simply replaced with the concept of a favorable risk outcome. There is no pat on the back or reward associated with prediction. Divergent traders simply follow price and are aware of this far broader universe of possible outcomes. In the trading game the price is all that is necessary to determine if you are right or wrong. You do not need to dig any deeper into associated causes of price movement or predictive judgement. All you need to do is place your stop in that zone where ‘predicted unfavourable outcome lies’ to prevent you from falling into the abyss of unpredictable unfavourable outcome and leave yourself open to any possible favorable movement in price.

Now for the negative Nancy out there you might be saying…”blah, blah, blah, you divergent types are paralyzed with fear and will never make it in this world without taking risks”…….but if you dig a bit deeper, you will find that while divergent traders direct their focus on mitigating ‘adverse risk’ events through active management measures, in doing so they leave themselves open to any associated ‘favorable risk’ event. The divergent trader embraces favorable outcomes but just recognizes that it can come in many forms, from small to large. A far larger universe of favorable outcomes than what a predictor is looking for.

Let’s put it this way. Risk is a concept deeply ingrained with information and the concept termed entropy. Information is a particular aspect of risk which is a concrete description of a system state. In our description of anything that lies within this universe, information is a way to describe that exact state. If we possess perfect information about any local system state, we can transmit that information to another local space-time region and using locally available resources, we can theoretically exactly reproduce that system state.

Better still if we can define the initial conditions of a system state and understand the mechanics of dissipative force laws at work, then we certainly can predict the future state of a classical system.

Unfortunately however, nothing is ever that simple in this twisted universe particular given our ability to only be able to access partial information of a system state including the nested semi-closed architecture and differing entropy levels of system within system. It is the error in our predictions that give rise to the ‘quasi stability and fragility of it all’ and the emergence of non linear emergent structures that we never see coming.

Now in terms of a description of a local system state, risk represents all the possible configurations that can be created using locally available resources without any road map to guide you.It is the complete array of all possible future states of that locale in space-time.

Without access to perfect information, the predicted states are simply a small subset of all possible states. Furthermore the array of possible future states can either be favorable or unfavourable states.

Like information itself, we can never destroy risk. The best we can do is to transfer what we know of it. The divergent trader does this by simply cutting losses short to close off the possibility of an adverse non-predicted outlier which transfers any chance of an unfavourable outcome to other participants and leaves the profit condition open to retain any beneficial risk event. …..but there are still many other adverse risk events that can be imagined and need to be taken care of by all traders such as liquidity risk, counter-party risk, regulatory risk etc.

The actual possible states are therefore far more vast than the deduced (predicted) possible states. In fact given the link between risk and entropy, like Richard Feynmans path integral formulation all possible paths extend across the universe itself. There is a risk of a supernova event in this galaxy that affects your trading decision and the risk of universal demise itself that makes a trade prediction problematic and ‘fat tailed’ in nature. Of course, all this risk is expressed deep within the financial markets itself and who knows what one chosen possible path will unfold.  Predictive risk…..pffft….that’s for cocky teenagers. The notion of risk relates to all the possible state configurations, known and unknown.

Trade well and prosper

Rich B

Leave a Reply