A Study of Fat-Tail Risk (paper)
“…whereas the normal distribution of the daily return of the S&P would suggest a negative three-sigma event (between -3.56% and -2.36% daily returns) should have occurred 27 days over the last one hundred years, this has actually occurred over a hundred times in the 81 years since 1927. And the “normal” likelihood of a negative four-sigma event is one day every one hundred years; yet we have seen this take place an astounding 44 times since 1927…”
NBR: Black Monday
On October 19, 1987 the DJIA dropped 508 points (-23%) in the largest single-day crash in history. This Nightly Business Report clip was broadcast that evening.
What A Black Swan Sounds Like
The S&P futures trading pit audio feed during the May 2010 Flash Crash.
Summer 2011: A Rough Period for Many Trading Strategies
Based on some of the charts over at C2, Summer 2011 was a pretty rough period for many trading systems. The S&P500 fell 16 % in just the first nine days of August, and continued to slide during the next two months:
During the carnage the market spanked many a trading system, sucking down their equity curves with double digit drawdowns. Here’s a few examples (click on the charts for more info):
Martingale Madness
At least once in their lifetime, every trader has been tempted by the seductive lure of the high win percentages and “easy” profits offered by Martingale money management (doubling/averaging down).
Its all nonsense of course, and every time I think about revisiting the Martingale, I force myself to take a look at the equity curve of a particular ES strategy on C2:
The Tails of Two Stocks
My previous post on S&P500 Black Swans got me thinking: The S&P500 index is a weighted average of 500 companies, right? And if the average is routinely making 6-sigma moves, what kind of crazy shit are the underlying stocks up to?
Let’s take a look at AAPL. Solid company, huge market cap, lots of trading volume. Given its size, it should move almost like an index, right?
WRONG. Take a look at a histogram of daily AAPL returns over the past 12 years (click to zoom):
Beware Black Swans Sporting Fat Tails
After surviving the August 2011 meltdown, it occurred to me that the market is experiencing six sigma events (crashes) these days with increasing frequency. To wit: In just the past 3 years we’ve had the 2008 Mortgage Meltdown, the Flash Crash, the Japanese Tsunami, and the Debt Ceiling Crisis. That averages out to around one market crash per year.
I was curious to see how fat these “fat tails” actually get, so I ran some quick tests. Here’s a histogram of the daily returns for SPY (the S&P 500 index ETF) over the past 12 years (click to zoom):
