Sunday, 15 February 2015

The first rule of fight club

10:07 Posted by The Thalesians (@thalesians) No comments

Many years ago, I remember sitting in a cinema watching the film Fight Club. Before seeing the film, I had little idea what to expect. In the film's most famous scene, Tyler Durden, played by Brad Pitt, stands up and starts a speech:

The first rule of Fight Club is: You do not talk about Fight Club. 
The second rule of Fight Club is: You do not talk about Fight Club. 
Third rule of Fight Club: Someone yells stop, goes limp, taps out, the fight is over. 
Fourth rule: only two guys to a fight. 
Fifth rule: one fight at a time, fellas. 
Sixth rule: no shirts, no shoes. 
Seventh rule: Fights will go on as long as they have to. 
And the eighth and final rule: If this is your first night at Fight Club, you have to fight.

Several years later, I walked into a bookshop near Union Square in New York. My eyes scouring the bookshelves spotted the book of Fight Club. This time I read Brad Pitt's speech. It's kind of exciting, reading famous words on a page, that you know. For me, it's like seeing a famous painting in an art gallery or hearing a musician perform live.

Whilst I don't advocate Fight Club as being some sort of recommendation of how to behave, the rules of Fight Club do spur some thought, when it comes to financial markets. Markets can often only focus on one theme at a time (fifth rule). If you hit your stop loss one too many times, your capital is withdrawn (second rule). Trades should go on as long as they have to (seventh rule). If you are a trader, you have to trade, you cannot simply be flat all the time (eighth rule). The first rule is of course not to discuss Fight Club. In financial markets, we break this rule repeatedly: the topic du jour (somewhat mangling the French language) is by contrast discussed and dissected by everyone.

Take for example currency volatility. For much of 2014, FX vol had been extremely low. In other words nothing was happening. There were grumbles that it was too low. Volumes for market makers had slowed to a trickle. Investors were having difficulty profiting from a market which was not moving sufficiently. Fast forward several months and of course currency volatility has picked up. Now, the grumbles are that currency volatility is too high. The most notable example of the pickup in FX volatility was in EUR/CHF following the removal of the peg, which both stung (but also aided) a lot of currency traders.

The problem is that we do not pick what regime markets settle into. We cannot choose. We are simply faced with price action we are given. I remember one of my friends saying more succinctly, that the most important job of a trader was to pick the "right seat". If you pick the right "trading" seat at the right time, for the hottest market, that will be one of your most important decisions. Take for example in the earlier part of 2000s, when for EM traders the best strategy only trade was simply long EM. Swim when the tide is with you. This is akin to adapting your trading strategy to fit the current environment. For the best discretionary traders, this is one of the critical questions they ask themselves: what is the current (and potentially next) narrative or theme of the market? In the market, all the lights are on, as in the picture above, but which one do we need to follow?

In practice, this again is somewhat difficult. From a systematic basis, we can create regime switching models. Often this is done for FX carry, where we use risk factors to scale back exposure during times of risk aversion. Indeed, I've done a significant amount of work on this for a client, RavenPack, using news data to filter exposure to FX carry.

Another approach is simply to diversify your strategies and run them at the same time, with similar weightings. For example, trend following strategies might work well, during times when volatility picks up. By contrast, harvesting carry performs less well during periods of heightened turbulence. We see the opposite during periods of risk aversion. So why not run them both, so their strengths and weaknesses compliment one another as an example. Rather than picking the one "right seat", we can pick several seats at the same time!

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you! 


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