Friday, January 16, 2015

Risk Intelligence: An Essential Part of Trading Success

Consider the talented weather forecaster, the skilled CIA analyst, and the successful sports gambler.  What they share is an appreciation of probabilities.  It's not that they have a crystal ball into the future.  Rather, they are intelligent about the range of possible outcomes and the likelihood of each occurring.

In David Apgar's terms, these individuals display risk intelligence.  The risk intelligent person is one who quickly learns about risks and rewards and adapts to changes in those.  Dylan Evans makes the case that risk intelligence is indeed a distinctive form of intelligence, not correlated with overall IQ.  As we sometimes see in markets, very bright people can make very stupid decisions about risk.  (See the Projection Point site for an example of a risk intelligence test). 

Let's take two traders.  Both are long a market that has been trending upward.  The trend has lasted long enough that the trade has gained popularity and the position is widely held.  The first trader cites "price confirmation" and the possibility of a "parabolic" move and increases his position size in the trade.  The second trader experiences the same enthusiasm, but looks at positioning, reassesses risk/reward, and buys some inexpensive downside protection with options.  When the market stalls and traders run for the exits in the crowded position, the first trader draws down meaningfully.  The second trader holds onto the vast majority of gains.

*That* is risk intelligence.  The first trader is carried away by the market move and becomes risk-stupid.  The second trader draws upon risk intelligence to reformulate odds and shift exposure.  A great deal of trading success occurs when emotional intelligence--our awareness of our experience and ability to adapt to that--triggers risk intelligence.  It's not that successful traders control or eliminate emotions; it's that they use emotions as information in assessing and reassessing risk.  

The traders I know who have been quite successful sometimes take higher levels of risk, sometimes lower.  They are distinguished not by their level of risk taking but by the intelligence of their risk taking process.

Further Reading:  Emotional Intelligence and Trading