The design of investment strategies is based on a number of premises. The first one is that the future will have some resemblance to the past. The second one is that the future will never be (exactly) the same as the past. And the third one is that the future will introduce some unforeseeable events.
The first premise is the easiest to deal with. Regularities in the behavior of markets can be used as the basis for assumptions about the future. These assumptions can be used as a predictor for future behavior.
The second premise is a much harder one to deal with. However, noise and other types of disturbances can be introduced to account for deviations in future behavior. In our blogpost of 31 January 2018, we concluded that, despite the atypical behavior of markets since the inauguration of Donald Trump, our models were able to uphold themselves.
The third premise is one of a very different nature. It is like roaming in the dark. Writing down a large number of ‘What if…’ questions helps, but you can never be sure that you lay your finger on an unforeseeable event that will actually take place in the future.
The event that happened last Monday during after-hours trading, which we dubbed the 2018 Volatility Flash Crash in yesterday’s blog post, was certainly not on our list of unforeseeable, let alone foreseeable events.
Although These Dutch Guys still believe that approaching sentiment among stock market investors with a contrary view is not fundamentally flawed, we also think that last Monday’s event has shown that new mechanisms (most probably caused by the growing number of trading algorithms present among traders) are active in the stocks markets which make volatility go haywire. And that we ain’t seen nothing yet in that respect.
These Dutch Guys have come to the conclusion that the investment strategy that underlies their models does not have a place in the future. In our belief, it is foreseeable that last Monday’s event will repeat itself in one way or the other in the (maybe near) future. And there is no way our strategy can guard itself against these rapid movements in volatility. These movements were not something of the past, they have become part of our present and they will definitely rear their (ugly) heads in the future.
Our models have become the First Victims of the 2018 Volatility Flash Crash. Although it makes a nice slogan on a t-shirt, we feel sad that this is the case. We have no other option than to bring our models to the eternal hunting grounds.
And these are the final words written on this blog.