Financial Risk Models

From the Mises Institute blog:

Although the mechanical philosophy is long dead and buried, our age is not without its own dogma regarding properly scientific explanations. Today, the prevailing belief is that any real science must be composed of mathematical models, models which yield quantitative predictions about some class of events based on particular, initial conditions, also specified numerically. Once again, the currently popular methodology has been imposed on diverse disciplines with little regard to whether it is suitable to their subject matter, but simply because it is thought to be the only respectable way to do science. The philosopher John Dupré calls this "scientific imperialism," meaning "the tendency for a successful scientific idea to be applied far beyond its original home, and generally with decreasing success the more its application is expanded" (2001, p. 16). Once again, we see a frantic effort to generate models fitting the accepted paradigm, with little regard for the realism of the assumptions and mechanisms from which they are constructed.

In my mind this relates prettly closely to this post from Brad Setser (be sure to read the comments which wade deeper into modelling and risk measurement). The basic problems in risk management seems to me that assets are assumed to have inherent properties like the physical bodies. Particles have mass, position and velocity while assets have price, varience, and correlation. I call it a basic problem because these aren't really the properties of the asset but are the properies of transactions.

Transactions necessarily have assets, counterparties, prices and times associated with them but assets need not be part of a transaction. A series of transactions in two identical assets need not have a realtionship at all if the counterparties have no contact. The existence of exchanges and the requirments of open-outcry and disclosure get around this basic problem, creating attachment between transactions but I am not sure this does much more than create the illusion that assets always have prices and those prices move in continuous fashion.

Stop That!

If I turn and look up from here, allowing myself to squint a bit, I can actually see the stop levels on my long bond trade. Clearly there is a disconnect between what I see and what the market sees. I also would say there is a bit of a gulf between the Fed's view that o/n rates are accomadative and the long bond's view that the gov't has run out of paper to print bonds on.

While I'm at it does anyone out there really believe that the unemployment rate is improving. I am going to go out on a limb and say that some day economists will look back at this period and realize lots of people could not admit they did not have jobs.

No more bond shorts until we make it back above 4.57 yield.

Trading your emotions

The most important lesson I have learned in trading is that predicting which way the market will move is only about 10% of the game. The odd thing is that it is predictions and opinions that completely dominate the news coverage. Brokerage reports indicate price targets and pundits always declare either a bull or bear market. For me I have found that the day to day volatility overwhelms such insights even if they are correct. After watching the markets for several years, recognizing a trend becomes easy but actually participating in it is always difficult.

If prediction is 10% what is the other 90%? Risk management. How to set stops and take profits to minimize your own emotional reactions. That is where the money is in trading. Taking profits when others are euphoric and having capital to buy when others panic. For me, a large part of this involves keeping position sizes relatively small and if I make a bigger bet I do it in the options market to cap the loss.

I have been reading my own posts and generally realized it fits pretty well into the "predict the markets" mold. While it is important to have a game plan and future expectations the actual position management is really what dominates long run performance. From now on I will try to focus more on that management. It may get cumbersome at times with repeated stops being hit in the same trade before I give up or the trend works out but I believe it will add value by seeing how good risk management actually creates the profits.

I called this post "trading your emotions" because that ultimately is what risk management accomplishes. It is impossible to tell if the market is irrational when you are not rational yourself. To keep my mind clear and open to both sides of the market I manage my positions so that I literally don't care which way the market moves.