Traders and Risk

This week marks the one-year anniversary of the collapse and bankruptcy of Lehman Brothers, events many in the financial and political worlds regard as the unofficial tipping point of the global economic crisis and a massive meltdown in the value of markets.  For traders, this has indeed been a year of relearning risk.  After all, at its core, trading is about taking risks. There is no way to avoid taking risks while trading. Risk and trading are joined at the hip. In fact, you could say that trading and risk are so intimately tied together that controlling risk is the essence of trading. Knowing when to take risks; and when to get rid of them; and how much risk to take is at the heart of trading.

The word risk can be defined as exposure to the consequences of uncertainty. This implies that risk has three components:

• Uncertainty – unknowable and unpredictable future events
• Consequences – a potential effect due to an uncertain event or series of events
• Exposure – a financial stake in a given outcome

For example, in the oil market there is uncertainty surrounding the demand for oil due to the economic growth rates and energy consumption rates of the major oil consumers. There is additional uncertainty due to the unknown psychological perspectives of the market participants. On the one hand, the consequences of this uncertainty may be a large rise in price if demand increases thereby causing buyers to be more anxious to buy than sellers are anxious to sell. On the other hand, the consequences may be a large drop in prices should the economy sputter, demand drop, and the sellers become more anxious than the buyers.

Of these three elements of risk, the only one that is in the control of the trader is exposure. When a trader makes a trade, this only controls the exposure. The uncertainty and the consequences remain. There is nothing you can do to alter this reality.

Many traders try to control the uncertainty or to predict it. This doesn’t work. Like trying to predict the weather more than a few days in advance, predicting the markets is almost impossible. There are too many players and too many unknowns for anyone to reliably predict the outcomes of the uncertainty in trading.

Instead of trying to control uncertainty, master traders focus their attention on timing and position sizing of their trades. The markets and what they do are not in your control. In contrast, what you do in response to what the market does is in your control. Reaction instead of prediction. This is the way of the master trader.

It may seem like a little point. It isn’t. This difference in perspective is the key to being able to trade effectively because it makes it much easier to reverse course and exit a losing position. It also makes it much easier to persevere in the face of a series of losses without losing confidence.

So don’t worry about what the markets will do. Worry about what you will do when they do whatever they end up doing.

Tagged as: Curtis Faith, Lehman Brothers, Oil, Risk, Trading, Uncertainty, Wall Street