# Minimum Tests to Detect High Volatility Risk, from James Sogi

The problem that a short lookback period does not account for potential volatility regime change is well understood. This is really two questions First, what is the lookback period? Second, how does one accommodate quantitatively for volatility change?  This might be addressed in different ways. First, look for volatility similar to high volatility regimes such as big moves. Second, in Iceberg Risk, Kent Osband suggests taking two distributions, a normal for current everyday entry/exit, and one for outliers and tail risks, and combining the two. Risk control, money management principles and use of leverage could be combined with the trading signals and by using eight-sigma for the risk factor but a normal curve for entries. Phase in could be graduated as survival odds of low volatility drop, and reduce leverage rather than increase it.

Another approach is from Strange Curves, Counting Rabbits, & Other Mathematical Explorations by Keith Ball from the field of information theory. The question in his example would be how to compute the minimum number of tests to give a robust reading on the number of children with a certain blood condition. The analysis is similar to the finding the one different coin out of nine with the minimum number of weighing problem, which is solved by dividing the 9 into 3 groups. Rather than equal probabilities as with coins, Ball poses the problem of testing children for a rare blood condition. This is similar to testing for a tail event in the market using a binary protocol — is, or is not, a tail. The number of tests is m and the test is computed as 2^m to be greater than n. For n=3200, then m=12, or 4096, which is greater than 3200. This provides a simple rule of thumb, that might be applied to divide the period into 12 samples, or a lookback of 266 days. The results is derived from principles of entropy as the minimum number of tests to detect the condition. Applied to markets, the lower number detects the cycle changes better. The number of tests might be the divisor of the sample to compute the lookback period. The rare condition to try to detect is the risk of a large excursion. The empirical occurrence of a four-sigma event has a probability of 1/400 or .0025. Another rule of thumb would be 1+2mnp, or 1+2*3200*12*.0025=196. Still some additional risk parameters are needed for the eight-sigma events we're seeing again per the Osband approach for protection in the turns.

Another method would be to change trade parameters to fit expanded volatility, and read the newspaper to follow fundamental changes. And there is truly no substitute for experience and good judgment and a good attitude.

## Eric Ross writes:

Models are based on backtesting. Models are based on prior market moves that have happened. Thus, quants are nothing more than historians trying to predict future events from past performance. So, why is Wall Street looking to go black-box and and substitute historians for human traders? Isn't the human element of guts and feeling a powerful tool to trade by, when combined with charting and experience?

## Rod Fitzsimmons Frey explains:

The heart of the scientific method is, say something testable, then try to disprove it by testing. If you cannot disprove a hypothesis, you may use it as though it were true (it is now a 'model'); however, continue trying to disprove it, and as soon as you do, cease using it.

Counters try to apply this method to markets. The only way to apply the scientific method to markets is to form a hypothesis (the market goes up every Monday after a down Friday) and test it against historical data. There are well-established statistical tests to take a certain number of outcomes (X number of up Mondays after Y down Fridays) and say something about the odds that such an outcome happened by chance. If the odds are long that something has occurred by chance, you may be wise to place a bet the next time the conditions occur.

Insofar as human beings have invented the scientific method and its servant, statistics, nothing could be more human than applying these tools to the market, as we have to medicine, evolution, physics, chemistry, physiology, agriculture, biology and botany.

Aristotle teaches us that we should apply only the level of precision to an inquiry that its nature allows: seeking more or less precision is a fool's path. The debate is about how much the markets will yield to scientific inquiry. The view of the Palindrome is that the markets are more akin to psychology and sociology than physics; the truth of the markets is determined by time and place and one must not trust the past. In other words, do not attempt to apply the tools of physics.Intuition, common sense, and experience taught many things that were eventually shown to be wrong when the scientific method was applied — the Earth's being flat and heavy objects' falling faster are obvious examples. I wouldn't trust intuition, but maybe I have no guts.

Fortunately, unlike psychologists, priests, or economists, we in the markets have an excellent scorekeeping mechanism.

## Denis Vako remarks:

The "little birdy" model in the paper Mutual Information as a Tool for Identifying Phase Transitions in Complex Systems by Robert Wicks, Sandra Chapman and Richard Dendy covers regime change, clustering, entropy and velocity — all in one place!

## Russ Sears extends:

This is similar to the "credibility problem" actuaries face with Property and Casualty insurance.

Sometimes volatility changes due to a jump in the frequency of claims, but usually a regime shift occurs by when the size of the average claim jumps. New rulings or litigation or creative lawyers, besides more ordinary causes like inflation or new treatment cost.

The individual large jump should be looked at closely. Is it a new cause, or just an extreme example of current events? In other words, does this set precedent? Has the target changed, under new rules, or has the shooter changed, fighting more aggressively?

The volatility changes are important. Likewise it takes time and many more claims to establish a new norm.

Property and Casualty companies react to high-cost hurricanes poorly at first, due to the unknown of who got stuck with what claims. Then they rebound due to a softer regulatory environment and a mistaken assumption that because it happened once its more likely to happen again.

## Gary Rogan writes:

Unlike regime changes in the physical world that are usually tied to the invariant physical laws, regime changes in the markets have no reason to have any specific characteristics because human beings are actively trying to outsmart the system while at the same time other human beings as well as random, from the financial markets point of view, physical reality changes inject error signals into the markets. It is also unknowable when the change phase is over and the new regime begins. It is futile to hope that any amount of backtesting will result in a reliable model. While the regime is constant, backtesting works, but when the regime unpredictably changes it stops working.

# Fear, from Ken Smith

September 4, 2007 | 2 Comments

Bad news is always around. Bad news and dire predictions are reasons to dump holdings and perspicacious traders are aware of this. They game the news, game economists, game everyone. Fear drove me out of a position Friday; had I held I would have had a profit to take as of half an hour into the trading day. I let fear temporarily overtake logic.

Join the team! Fear and emotions have driven me out of trades, have prevented me from taking positions. Today, after dawn patrol, I wanted to enter the market, but emotions prevented me. It seems one should just buy the dips and not look back, accept the risk of a drawdown.

## Alan Millhone remarks:

I wonder if we had no TV, did not look at magazines or newspapers, and stayed focused on the data at hand — would that exclude emotions and thus make traders more successful? The news media can twist anything — and when you see something you automatically believe it!

# Cloudbreak, from Jim Sogi

On certain days huge waves triple normal size break on outside reefs normally too deep to form a wave. These are called cloudbreaks. Catching them requires sitting way outside of the normal breaks to avoid getting caught inside by a breaking wave and crushed and drowning. The paddle is typically three times farther than to the regular breaks.

Today's typical faux fireworks surrounding the FOMC announcement showed a 30 point variance at the extremes around the announcement, which is approximately triple the excessive burst of absolute volatility during the recent announcements. This seemed in line with the approximately tripling of recent absolute volatility measured by daily ranges and swings. It was a good day not to get caught on the inside, and to sit and wait for the waves on the outside of the reef where the wave usually do not break except for the really big ones on the outside cloudbreak.

The other sign of a bottom is the amount of chatter, which dribbles down to close to 0, as if most folks expect the market to go along with their accounts. As the market picks up and heads back up to the highs like it did over and over again in 2000, more wine added to the vat.

Think of it this way. If the market wanted to suck in the most people possible, in maximum deception, it wouldn't just go straight down taking the few with it. It would go back up, to suck more and more back in, give them hope. It might even make new highs to bring more trend follows in on the wrong side, like it did yesterday by making one little new low to bring in more shorts right at bottom tick. It would do it several times to train them into believing that buying the dips works, then it would go down like 2001 and 2002.

Another sign of a bottom is stories the wives tell each other about the huge losses in their husband's accounts and anecdotes about such losses sifting about, worried calls wondering when and if to bail. The cruelest psychological trick is to give the person hope, hope of escape, hope of redemption, then dash those hopes.

## Eric Ross replies:

I've been surfing Port Arkansas (Corpus Christi, Texas). I took Monday and Tuesday off as relaxation days because I don't like to trade the day before and day of Fed meetings. However, there were no cloudbreaks to be found. Knee high to waist high is all I got. Swells every four seconds, and while the Third Coast surfers of Texas smile at days like this, I was disappointed (but looking forward to the September breaks in Costa Rica).

# No Credit, from Eric Ross

I guess I'm looked at as a deadbeat. In my personal financial world I have hardly any credit. I buy all my cars in cash. I still rent. I'm liquid except for the money tied up in land and commercial buildings I own. The only credit is a revolving credit line for construction loans and business needs but that is not personal. I have super low leverage with my clearing firm on purpose.

When the '99 markets came down I watched people lose their entire lives, built on credit. I lost more money, as did most of those at my daytrading shop, than many will earn in three lifetimes. Lucky for me the money was not around long enough for me rack up credit. I walked away debt free except for my Audi, which I paid off right away.
I had to downsize but at least I did not lose boats, cars, homes, lofts, and wives. When I entered the group of land speculators, became one of them, the first thing they taught me was to stay out of debt in your personal life.

Buy and hold land and buildings. Flipping is for those who come and go in the business. The one thing that enabled me to obtain business credit was my liquid worth and the proper bank.

A very simple solution to being in debt is to make more money which in return will create higher debt. Just look at all those shiny new cars and big homes.

# The Bust is Boom in One Region, from Eric Ross

March 27, 2007 | 2 Comments

I'm not sure where the numbers truly are when it comes to the housing bust of the recent bubble. However, I can tell you it has had a very small affect on this area and our absorption rate is healthy. Homes in the ranges of 1.2 to 4.5 are moving along in a normal pattern of sales. They are projected to jump by 12% and we are on track. One of our projects, 2100 acres of land (956 unimproved), is looking at a fair market value of 158 million. We have 14 buyers who are currently in the running for our property and expect bids to come in shortly.

The sub-prime situation has hit the lower income and mainly ethnic groups in San Antonio. Yet, I do not see a slowdown in midsize to high end homes any time soon. In fact, both West Coast and East Cost monies are flowing in to purchase homes and land.

Of course, I expect somewhat of a bump eventually, due to many sellers not going being able to unload their homes in the up and coming market. I also figure that sellers will not want to write checks, at closing, to buyers, and will sit and ride whatever storm is brewing.

Not only is the bust bringing boom to the home sales market in the South West Region of Texas, many corporations are moving into and around the city of San Antonio for the economic reasons such as inexpensive and abundant land, cheaper labor, and weather.

I came to this region two years ago to capitalize on the next recession, the next long and harsh bear market that will hurt the east and west coasts job market and real estate market, and cause individuals to migrate to less expensive areas. I think my timing was early but I know I am on the proper track.

Nonetheless, the bust is nothing but boom in the southwest region. In fact, the proposed 14-lane highway called, the Texas Trans Corridor is looking to bring in more real estate money. I will find out more in two weeks when we have a lunch with Congressman Gonzales to discuss the NAFTA and commerce.

Certainly in greater Sydney (Aus), where the housing market broke down earlier than the States, middle to high-priced houses on the coast have had a relatively solid floor bid. The poorer areas (and last into the "bubble") are coping with the worst of it.

# Keep the Faith, from Eric Ross

I liked what I read on each of us "holding hands" and being supportive of everyone we know who has a deep interest in the market, whether in stocks or real estate. Excessive negative talk will serve no useful purpose and will undermine and erode our confidence.

Forgive me, as I hardly ever post, but isn't the above "statement" much the same as a trader who doubles down in the hopes the position will work out? Or the idea, "stick your head in the sand," and hope for the best?

Do you not think that the Asian Flu that hit the markets a week ago was a "signal" much like back in April of 2000, when the drop hit the INDU hard? Is the weakening of the US dollar, the geo political climate, and the "Asian" markets (down around 500 or so as I write) not pressure on the "bull." How about the simple saying, "what goes up, must come down?"

I would save the handholding for a nice romantic getaway. I prefer to listen and watch what the "forces" are telling me, and capitalize in any move, or any business cycle that may come. The Art of War, my friends - I know it's been used in cheesy books and movies. But Sun Tzu's methods are basic principles in life.

# Podcasting, from Eric Ross

Podcasting is great! Ever since I decided to leave my life as a full time trader and enter into the world of land development, which allows me far more time to play, believe it or not, I have focused on podcasting.

My record label is featured on more than 300 podcasting shows worldwide. I was introduced to podcasting a few years ago when I was performing on the Island of Ibiza. Two young Brits from London wanted to come into the DJ booth of the nightclub where I was featured. Two nice looking ladies, so I said sure. They pulled out their Mac from a backpack (clubs in Ibiza all have wireless internet), pulled out their pods, and asked if they could plug into the second line out in the mixer. I was puzzled and a bit nervous as 5000 people where screaming and dancing to the sounds I unleashed on them.

I did not want dead air or anything to interfere with my mix. But, I let them plug in. Next thing you know they pull out a microphone, about the size of a pen and start commentating on my performance. They were broadcasting me worldwide. I was absolutely amazed. I mean a radio station that is portable. Great PR for my label and new release.

Needless to say, their podcast has grown to more than 100,000 individuals who tune in and listen to their show about producers, DJs and the Ibiza scene. Radio as we know is dead. Period. Technology has advanced the radio industry, pirate radio is over. Anyone can have a voice over America or the world. It is brilliant. I personally do not have a show but I work with podcasters all the time, send them material, do interviews. My label is sponsored by Apple, so whenever I appear at a Mac store, they set up a podcast. The Iphone will revolutionize podcasting once again.

And to think, I use to sit in a room and watch five screens all day long for a living. What was I thinking?

# Even Melduke is Flummoxed by the Energy Markets, by Sam Humbert

1/10/07 Momentum

The drop in the price of crude picked up in early Tuesday morning trading with the low below \$54 a barrel. This caused selling by chartists and the bearish sentiment increased. As I looked at my positions, the losses grew, and even though natural gas was holding up, the portfolio took it on the chin. It's not the first time, and I'm patient. [Read more here]