How to Exploit Randomness

Roark · Mar 1, 2011

Suppose you have been ship wrecked on an island. Desiring to return to civilization, you build a raft with a primitive sail to take advantage of wind power. Unfortunately, the wind blows randomly in two different directions. The first direction will drive your raft toward civilization. The second direction drives the raft further out to sea. What to do?

When the wind blows in the first direction, put the sail up. When the wind blows in the other direction, reef the sail and wait for the wind to change. And so it is with trading.

mcgene4xpro · Mar 1, 2011

Quote from Roark:

Suppose you have been ship wrecked on an island. Desiring to return to civilization, you build a raft with a primitive sail to take advantage of wind power. Unfortunately, the wind blows randomly in two different directions. The first direction will drive your raft toward civilization. The second direction drives the raft further out to sea. What to do?

When the wind blows in the first direction, put the sail up. When the wind blows in the other direction, reef the sail and wait for the wind to change. And so it is with trading.

so you see the direction of the wind first. Thanks for the hint

1a2b3cppp · Mar 1, 2011

it will be awesome when the wind chops back and forth and it's blowing the way you want to go so you put your sail up only to be caught by a huge gust in the opposite direction.

"And so it is with trading"

Bakinec · Mar 1, 2011

Quote from Roark:

When the wind blows in the first direction, put the sail up. When the wind blows in the other direction, reef the sail and wait for the wind to change. And so it is with trading.

AKA the trend is your friend.

How come the simplest and realest trading concepts are so often overlooked?

Roark · Mar 1, 2011

Quote from mcgene4xpro:

so you see the direction of the wind first. Thanks for the hint

You could do it that way. However, suppose you note that about 75% of the time, the wind blows in the desired direction for about an hour after dawn each morning. So instead of seeing which way the wind is blowing before putting up your sail, you put it up each morning at day break to take advantage of the noted tendency. While the overall direction of the wind is random, there are streaks of non-randomness that may be exploited. Think of blackjack when the card count reaches a certain level.

trendo · Mar 1, 2011

Leave the sail up all the time. It's possible to sail indirectly into the wind by going in a zig-zag pattern. Why waste precious time just drifting? I'm not sure how that applies to trading.

Roark · Mar 1, 2011

Quote from 1a2b3cppp:

it will be awesome when the wind chops back and forth and it's blowing the way you want to go so you put your sail up only to be caught by a huge gust in the opposite direction.

"And so it is with trading"

You are correct. If the wind direction changes frequently, it will be more difficult for the castaway to return to civilization by relying on wind power. If the wind blows for hours in one direction or the other, it will make the task much easier.

So perhaps traders should look for markets where trends tend to be longer?

1prometheus · Mar 1, 2011

In this case you are not exploiting randomness but rather autocorrelation. If in period 1 the wind direction was not correlated with wind in period 2 (the time it takes you to get the sail up) you would make no progress.

So in fact your example demonstrates pattern detection not the exploitation of randomness.

Roark · Mar 1, 2011

Quote from trendo:

Leave the sail up all the time. It's possible to sail indirectly into the wind by going in a zig-zag pattern. Why waste precious time just drifting? I'm not sure how that applies to trading.

True, it is possible to sail against the wind direction in a zig-zag pattern on a reach. However, that requires a boat with a keel. Such structure is not present on a raft with a primitive sail and therefore cannot progress in the desired direction against a headwind.

Soon2Bgreat · Mar 2, 2011

...this assumes there's enough volatility for the wind to get you sufficiently close to or on land - otherwise it's a pointless argument.

We also have to assume you can sail and manage to not drown in the process - there are plenty of other risks to mitigate.

...catch my drift?