The financial markets are a battlefield and in very real terms we know what a battlefield represents. Very few winners with many scarred losers….and I really mean very few long term winners. One thing that war guarantees is that there are less winners and losers than what started out in the game. The longer the battle endures, the less winners. There is an asymmetry here that cannot be defined by very symmetrical normal distributions which comprises that asymmetrical element we give to our broker and that asymmetry we give to other participants from simply being wrong more times than we are right…though we might not like to admit it.  As Nassim Taleb has been recently convincing us in his twitter posts, when you are dead or severely incapacitated there is not a symmetrical totally alive or partially alive alternative. There is  just alive.  In any complex system, there are just many more ways of being dead or mortally wounded than alive. That’s why the Pareto principle is alive and  well in a complex system such as these markets.

So in recognising that there are many more victims than winners in the marketplace, why do we place so much time in trying to predict and be right? The markets themselves convince us time and time again that there are many graves in traders heaven and there are only a very select few living the dream of being alive.

Why don’t we take the other side of this stance, like the casino operator and the broker and simply predate on those who are wrong? In being right, we like to think we can predict a future path from a historic state. If we want to predate on this philosophy and lie on the other side of the transaction then we want to protect ourselves from this predictive stance of future right. To do that we need to use the past to defend ourselves but keep our minds very much in the now to predate on this principle.

This blog post explores this notion.

In the never ending debate between prediction versus trend following it pays to enquire with a critical eye to this dispute as you may just see how difference of opinion shapes a philosophical stance taken.

Harvesting Alpha Through Prediction

Let’s assume we are in the ‘prediction’ camp to harvesting alpha from the market.

In taking this stance of the ‘predictor’ we are assuming that there is a market and it’s signature is price. We are standing passively outside this system and adopting a notion that there is a specific future path this market price is more likely to take based on a historical projection of past participation represented by the ‘signals in the noise’ of past market data…..which excludes yourself and others who are currently on the right hand side of the chart observing this market from outside in and lie in the ‘now’ of market potential or possibility as opposed to the ‘now’ of participation.

The logic so far is good….however the assumption embedded in it for the future is perhaps not so good. The assumption assumes that the historic behaviour of the past possesses sufficient momentum to follow through into the future (a stationery prediction of the future) but misses the essential feature of the ‘now’ in the market where what was right can now be wrong. So as you passively stand outside the market observing, you see this lump of historic arbitrage ‘now’ that is ready to eat and for the taking.

But that is not strictly correct. In a highly efficient market with a fine slice of inefficiency the price has already fully reflected this past behaviour of signal and noise and the inefficiency does not lie in the past at all…but in the now ……… for as soon as you interact in the ‘now’ of the market by an entry decision or an exit decision, your participation causes a change in the state of the market in addition to giving a slight piece of the pie to the broker …..or a price oscillation from your participation. The inefficiency arises from the oscillation between a past stationery assumption of the future and the ‘now’ state.  If you are first to partake in the feast, then you are right…..but if you are later to the table, then you are slightly less right, more less right, breakeven, less wrong, wrong, very wrong.

The central banks are aware of this phenomenon and recognise that if their impact is big enough they can manipulate the future by interceding in the market through intervention measures to apply a limit to the way the market behaves…..and as a result, attract the legions of predictors into the fray who are quick to the feast on this contrived market condition with their predictive models.

The ‘predictors’ are not blind to the fact that their participation in the market ‘eats’ this predictive certainty and you can see it in statements made from the prediction camp “that alpha is never long lasting”……and “no strategy ever lasts”. They are aware of the impact of future participation in ‘eating this historic arbitrage’ but are relying on the principle that they can see it first or see it better. Hopefully they can extract that alpha themselves before other participants see it. When that occurs, the historic arbitrage disappears completely and we need to revert back to our historic roadmaps to look for another ‘alpha signal’.

Success in this philosophy is therefore based on the principle of ‘the early bird catches the worm’. For those who are slow to the feast of ‘now’, they will be left wanting. In other words, in this battlefield it is a game of the ‘quick draw’ with cost of  the bullet going to the broker.

So there is a pressing urgency in this philosophical viewpoint that necessitates immediacy as opposed to latency and precision in harvesting historic opportunity to ensure that you simply don’t miss out on the opportunity. The well resourced quant houses therefore search for precise elegant algorithms, the lowest transaction costs available and the best that latency can buy, so you can quickly project that historic condition replete with entry conditions and exit conditions into the brief future with precision to ensure you are not last to the table of fleeting arbitrage.

For the other less well resourced predictors out there that are too slow to the draw (eg. the retail trader) as they simply don’t possess the resources to develop the best prediction engines for this short term certainty….they adopt a slightly different stance recognising the competition for the ‘signal’ and are prepared to be more patient and therefore wait for the optimal moment to strike with pending orders based on this past historic road map. In other words, these guys are not the quickest on the battlefield but they are the most precise. They are the snipers.

This faith in the historic road map as a guide for the future reveals specific points of entry in the past that were better than other points. In sacrificing immediacy, they elect for pinpoint precision as the retail trader needs more time to get their ducks in a row and defeat the quant houses. The assumption is still that the historic path will continue into the future, but there is a better point in time to ‘strike’ to beat the early bird in this game of fleeting arbitrage exploitation.

The commonality however that exists in this philosophical viewpoint between the quick draw and the sniper is that your survival prospects are based on a projected single ray of opportunity that is only ever fleeting in nature. You hope to capture all of it but are prepared to capture some of it……but you cross your fingers and just hope that you are not the unlucky predictor that lost all of it……..so in contriving your precise future path, you may be tempted to optimise and streamline your engine taking away all unnecessary fluff that compromises your ‘quick draw’ or ‘streamlined flight path’ in the ensuing gunfight…..but you have to be very careful in this process as your sacrifices will leave you more exposed to a mortal wound from being wrong as opposed to perfectly right.

This all makes great sense provided that the future market is stable in the context of the past market….in fact that would be the optimal way to approach this battlefield if this were the case……but where the philosophical approach lacks finesse is in the under-appreciation of the impact of the more immediate now on the market state. The current battlefield.  Exploitation of a past signal leaves wounded predictive participants which comprises all those predictors in the gun fight that weren’t as fast or precise as the other guys. Those participants who were simply late to harvest the alpha signal.  The market has the last laugh as its history brutally confronts the trader with a simple truth statement. “There are many more ways of being wrong than right’.

……and it is those wounded participants that the price follower relies on. As always on the other side of the “predictor” (or the quick draw and sniper) lies the “price follower” on the armored cart with the gattling gun. The predictor relies on projecting price, and they achieve this by using historical price as a method to project forward and if it doesn’t eventuate then they will be wrong….maybe dead wrong.

Harvesting Alpha Through Price Following

A price follower on the other hand focuses on the ‘now’ and predates on predictive fallacy, namely the wounded predictive participants. Now this form of arbitrage is persistent and can never be totally arbitraged away. It may hide itself for a while but it is always lurking. It relates to the arbitrage that arises from being wrong.

Price followers who predate on this form of persistent arbitrage always need to be in the ‘now’ to participate in this battle and feed off the wounded and dying, but in doing so we need to be heavily armored or defensively placed  to protect ourselves from the quick draw or sniper and the shrapnel of the battlefield.

The way we ensure we are always participating in the ‘now’ is not by firing off our gattling gun at every beck and call in price as we don’t want to be quick, but rather we just lie in wait for an ambush on chosen ground or in our slow armored tanks by observing price. You see inside price is every clue you need for the well-versed tracker. For greatest effect we wait to spring an ambush when the living and wounded cluster together for their last stand. We let them fight the battle until that point as they have a very convenient way of lifting the odds in our favour.

So we don’t worry about the past in the sense of projecting future price at all. We observe price now and wait till it moves into our preferred killing ground.

Price followers can absorb all the bullets of the quick and accurate guys and then some because price followers are heavily armored. This armor is created by using the past in a different way (a reverse way) to the predictors. Not by projecting past successful battles into the future but by examining the strategies of past battles and observing their failures. We project risk forward as opposed to projecting price forward.  Each risk event of the past shapes our armor or choice of ground and the more armor for the ensuing fight or the better dug in we are, the better …….but you still need to continuously update the armor and your terrain as you roll forward in the war.

Price followers do not assume that the path of historic price will continue as a single path into the future and understand that in the ‘now’ with the frenzy of participant activity it can be every which way but loose. In fact they rely on this principle as they are heavily armored to take the hits of predictive certainty if they are wrong.  They create this armor by addressing the risks inherent in the many different failure paths of historic price to make it super strong. Not impenetrable by any means as all can die in this game with uncertainty….but super strong and it needs to be continuously updated.

So now we have the armor, we have selected our ground and are lying in wait by observing price. We have learnt the mistakes of every past battle, we recognize that every battle is messy, but we also understand that there are very few long term winners in this game…..but we like to think we will be one of them…..so we do our best to understand the history of losses so we are better prepared to avoid them in the future.

In following price, we humbly accept that price is always right and comprises the state of the market in the past right up to the now…..and for every moment into the future.  If we can follow it closely enough by shadowing it with thick enough armor (tight stops) to ensure that if we stray to far behind the right price we are punished with a slap, then we may have dents in this armor but we will always be alive on the battlefield.

If we predict price based on projecting the past and assume that this projection replaces the need to observe the price of the moving now, then don’t be surprised if you die from not following it close enough.

…and may you rest in peace pilgrim.

So in thinking this different way we can now ask the question. Was Jeff Bezos predictably right or did he just lie in wait with a system that was constructed from past failures that predates off those who were wrong? Aka  the predictive assumption that the retail environment was here to stay…..forever.

Trade well and prosper

Rich B