Today I would like to explore three concepts in trading that many traders have never thought about. Fragility, robustness, and anti-fragility are concepts that describe a trader’s psychology, risk management, and method.
Here are some general definitions:
Fragility is a word used to describe something that is easily broken, shattered, or damaged. It means very delicate or brittle.
Robustness is a system’s ability to operate without failure under a variety of conditions. Being robust means a system can handle variability and remain effective in challenging environments.
Anti-Fragility can be described as high-impact events or shocks that can be beneficial to certain kinds of investment methodologies. It is a concept invented by professor, millionaire trader, bestselling author, and former hedge fund manager Nassim Nicholas Taleb. He invented the term “anti-fragility” because the existing words used to describe the opposite of “fragility,” such as “unbreakable” and “robustness,” were not really accurate. Anti-fragility goes beyond these concepts; it means that something does not merely withstand a shock, but actually benefits from an outlying Black Swan event.
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Fragile Traders are new traders that struggle to survive the first year. Their psychology is fragile; they don’t make it through the learning curve because they expect to immediately make money. Learning to trade takes time, just like any other professional pursuit. Fragile traders lack the mental strength and perseverance to stick with trading until they are successful. They make decisions based on their pride, fear, and greed which eventually break their accounts.
A fragile trader has poor risk management. They risk a lot to make a little. Big position sizing leads to fragility because all it takes in one big adverse move to seriously damage an account.
A fragile trading methodology is one based purely on opinion that really has no edge. It is counter-trend, where a trader thinks the logical thing to do is to short uptrends, and go long downtrends, instead of going with the flow. Shorting bull markets and catching falling knives is a fragile trading methodology.
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Robust Traders are usually, but not always, trend following traders. There are many different types of robust trading methodologies that put the odds on their side.
Part of what makes traders successful is that they don’t put too much weight on any one trade. The most successful traders limit their total account risk on any one trade to 1%-2% of total trading capital. They carefully look at a market’s volatility and logical support levels to position size effectively and set appropriate stop losses.
Their risk management principles make every trade just one of the next 50-100 trades. This brings down their stress level, and turns down the volume on their emotions. They risk a little over and over again for the chance to make many times their risk.
A Robust Trader has completed the homework on their methodology, system, and principles. They know why their system works, and they understand their edge. They keep the faith in their systems, even during losing streaks, because they understand the realities of changing market environments. They know what kind of trader they are, so there is little internal dialogue of doubt or confusion; they just trade.
Because robust systems are generally trend trading systems, they can profit in both bull and bear markets. These traders need trends to make money, and don’t do well in choppy, trend-free markets or range bound markets. Their systems are robust because the trends come back around eventually, and the profitability of those periods, make up for the smaller losses in trend-free markets.
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The Anti-Fragile Trader is someone that puts on very small position sizes in low probability trades, but shifts huge amounts of risk to the trader on the other side of the trade. The methodology of the anti-fragile trader is to bet on the eventual blowup of the traders making high risk trades for a small premium.
The favorite tool of the Anti-Fragile Trader is the out-of-the-money option contract. For pennies on the dollar, they can control huge amounts of assets. While they expire worthless the majority of the time, when a random Black Swan event hits the market affecting the option contract, they can return thousands of percent on capital at risk, and makeup for all the past losses.
The creator of the anti-fragile concept, Nassim Nicholas Taleb, traded long option strangles, betting on both directions to capture any huge trend event up or down. A company being purchased and rocketing up, or a disaster and a company stock sent crashing, was hugely profitable for Taleb. He also bought option contracts on futures markets. The key is very tiny bets on these trades versus total account equity. Tiny losses and tremendous wins was what made the system profitable.
Anti-fragile traders grow stronger through losing trades by learning instead of quitting. Rough market environments don’t break them; it educates them on what to do different in the future. A trader who is mentally anti-fragile has no doubt that they will be a successful trader, and that only time separates them from their goal.
The anti-fragile trader wins in volatile markets and random Black Swan events, outside the bell curve of normal price movements. Taleb made a fortune in the Black Monday crash of 1987, and many other instances over the past 25 years.
What kind of trader do you want to be?