Talking Points:
- Markets follow uncertain paths, so plans need to made to account for different possible outcomes
- Assessing plans for scenarios that are improbable (not impossible), likely and very likely can make us more prepared overall
- We perform scenario analysis for discrete data (China GDP), an event (ECB decision) and general theme (risk trends)
See what live coverage is scheduled to cover key event risk for the FX and capital markets on the DailyFX Webinar Calendar.
Trading is a game of probabilities. Yet, too often traders approach with an unrealistic sense of certainty. That doesn't necessarily mean that market participants are recklessly presuming a particular outcome, but it does frequently result in a trade plan for only one scenario. For a trader that only prepares for only one possible outcome, they are either significantly curbing their participation in the markets or scrambling to come up with a game plan in the height of emotion to execute after the assumed path fails to materialize. A more practical approach to trading around data, events and themes is to have plans for various scenarios. That doesn't demand 20 different possible paths, but perhaps three - even two if one has a strategy adept at dealing with fast moving markets.
In an array of scenarios, there will naturally be a skewed weighting of probabilities. There is frequently a 'most-likely' outcome attached to a fundamental consideration and there are always highly unlikely outcomes. Naturally, there is a strong, negative correlation between probability and market impact. The more likely something is, the more preparation for its eventual development in the market. Realizing such a scenario translates therefore into little movement of the market. In contrast, an extraordinary surprise catches a bulk of the market off guard and thereby warrants the biggest change in positioning - which is practical mechanics to a big price movement. While appetites usually whet at the possibility of volatility (to frequently presumed to be fast moves in our preferred market direction), it is important to be practical about expectations. A high probability outcome deserves a more comprehensive strategy and understanding of the nuance of its more reserved market impact. A low probability event needs a looser strategy and more an appreciation of the volatility it can generate.
Approaching markets with an appreciation of scenario analysis can result in better preparation and better trade. The particulars of this analysis can differ with the type of development we intend to analyze. A data update for example can very readily be determined to have met, beat or missed expectations as the numerical outcome is conveniently quantitative. In contrast, general events don't always have a particular number to benchmark to establish market impact. Even more difficult to account for are themes. Not only do they frequently lack clear numbers, they may not come with a particular time frame and it can be difficult to establish what the speculative assumptions are before an update. We explore scenario analysis for all data, events and themes using China GDP, the ECB rate decision and risk trends respectively in today's Strategy Video.
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