Which cookies and scripts are used and how they impact your visit is specified in our Privacy Policy. It shows the left tail of the SPY daily return distribution. This can have detrimental consequences and is one reason for financial crashes and crises. If the stock declines through the trendline, triggers the stop, then reverses course and closes above the trendline, was your thinking wrong? Think of the way a gambling casino works. We also consider those events to be the price we pay for insurance against big losses. Very interesting and helpful article. Probability theory started in an attempt to better explain the outcomes in gambling and today it is still being used in Casinos. But they don’t move moderately far at once too often. Fat tail risk is the risk that arises when you assume a normal distribution on an observation that, in reality, has much fatter tails than a normal distribution. Let me now sum up some of the key characteristics of stock return distributions: Besides the Laplace and student t distribution, there are many other distributions that fulfill these requirements. Thank you for your comment and feedback. I bet if you expanded your dates for 100 years of market moves you find the same distribution. Therefore, it is very easy to work with a normal distribution. Estimating the probability of stock market crashes for Bucharest Stock Exchange 9 ‐0.15 ‐0.1 ‐0.05 0 0.05 0.1 0.15 Figure 1. For example, research by R. E. Davis of Purdue University has shown that a bullish symmetrical triangle is profitable 71.4% of the time for an average move of 30.9% over a 5.4-month period. The black swan of Covid 19 shows how your advised mitigation of risk strategies such a hedging and diversification as you say rightly may appear to be expensive at the time only prove very prudent to cushion the impact of such sudden moves even with the right probability models at inception. With a good strategy, the odds are weighted in your favor.. We have come to the conclusion that there are far better choices than the normal distribution. Check Out The “Black Swan: The Impact of the Highly Improbable” on Amazon. %PDF-1.5 %���� This means that a normal distribution dramatically understates the probability of small and very big moves, whereas it overestimates the likelihood of moderately sized moves. Don’t get me wrong, these huge price swings are rare, but not nearly as rare as the normal distribution claims. It seems so exciting as I watch it on CNN. No wonder that market crashes seem so unforeseeable when such models are used to assign probability values to them. The distribution for longer time periods such as monthly and yearly returns can look quite differently (more skewed and more normal). Just going through this post is so intriguing because I can only imagine what this all means to traders all over the world especially during this challenging and changing time. hޤVmO�0�+�q�P��v$T�ʐC��P?d��ҤJ�`�~>;i�E��w�s��� No information herein is intended as securities brokerage, investment, tax, accounting or legal advice. It comes down to probabilities. 70 0 obj <>/Filter/FlateDecode/ID[]/Index[64 19]/Info 63 0 R/Length 53/Prev 161276/Root 65 0 R/Size 83/Type/XRef/W[1 2 1]>>stream Thank you! The answer is no, it was really correct. The following diagram shows a normal (gaussian) distribution where μ is its mean and σ is its standard deviation. Using the tools of fundamental and technical analysis can help you increase the odds of a favorable outcome. Depending on the mean and standard deviation, the shape and position of the bell curve can vary. For instance, Markowitz’s Modern Portfolio Theory or the Black Scholes Model both assume that stock price returns are normally distributed. Therefore, since the stop loss is placed below the line, it is not likely to be triggered because the buyers at the line will keep the price from falling enough to trigger a sale. Another good choice, for instance, would be a Pareto (power-law) distribution. Nevertheless, the firm lost close to $5 billion in 1988 in the aftermath of the Asian and Russian financial crises because it dramatically underestimated the likelihood of such big price drops. It is still common practice to use a normal distribution to model equity prices. The student t distribution is already a definite improvement over the normal distribution. This site uses functional cookies and external scripts to improve your experience. These methods involve running event studies on options prices to complement the standard event study in stock prices. Thanks so much for your positive comment. That’s what I’ll present next. We borrow the probability theory mathematical models and apply them in different areas that includes financial markets.

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