"How can I avoid black swan news events in my strategy?"
By Dave Mabe
Another question from Jason D. (name used with permission, lightly edited for clarity):
Jason D.
I have a strategy where my average winner is $138, and my average loser is -$15. Great so far. But then there is one single trade that destroys everything. In one second, this stock price dropped from 95 to 55 dollars. It was an 82 standard deviation move! How can the strategy be adjusted to avoid these types of black swan events?
Dave:
Here's the chart of the trade Jason is referring to in his backtest:
Nasty halt and gap down in SIMO on 2023-07-26.
Sometimes you can find rules to realistically exclude outlier losing trades without curve fitting.
But even if you're able to do that, and your backtest appears clean, there's always a chance of a "black swan" event you can't predict.
If you're looking for a sure thing, trading is not going to give you that.
But the fact that there's inherent uncertainty in trading is precisely why most people can't do it.
Understanding and being well-calibrated towards risk is what separates traders from gamblers.
The best way to approach this kind of risk is to minimize its effect by doing two things:
Making sure your strategy has lots of trades
Sizing your positions such that the impact of any one trade is unimportant
This provides the best backstop you can create for yourself.
Trying to avoid the outlier at all costs can give you the impression you've solved it and, therefore, overconfidently risk too much.
Thinking about the risk of ruin should keep you up at night a little bit.
The fact that it's in your backtest is a good thing - it's showing you a clear example of what's possible that you otherwise might be blissfully unaware of.
Thanks for the question, Jason.
-Dave
P.S. Do you wish you had a column library that would tell YOU how to make your strategy profitable? My column library is now included with MabeKit