Thursday, September 15, 2016

Replacing Risk Taking With Intelligent Risk Taking

We all know the saying, "No risk, no reward."  In markets especially, we cannot make money if we're not willing to take risks.  Frankly, however, my experience working with traders is that the greatest problem is not with taking risk, but with the intelligence of risk taking.  Traders take risks that, ultimately, they are not emotionally prepared to handle.

I recall the trading days in which you could get filled on a long position at the market's bid price and either get out a tick lower or wait and see if you could get a larger gain when it traded at the offer price.  Most trades could be scratched that way and you got plenty of free looks at larger moves.  Once market making became algorithmic, that level of risk control--the hallmark of true scalping--became impossible.  The noise was simply too great for the amount of signal traded.

The same has been happening at larger time frames.  The most common concern I hear from active traders is the "choppiness" or noise of markets.  High Sharpe, trending moves are the exception.  Very often, the market will take out previous highs before moving to lows and vice versa.  This makes it easy to stop out of trades at poor levels.

Risk taking becomes unintelligent when the amount of risk we take is ultimately more than we can handle, either emotionally or business-wise.  The trader who routinely gets stopped out of good ideas--ones that often work out in the end--is trading more size and taking more risk than they can handle, given the market's signal to noise ratio.  Traders overestimate the precision of their entries, leading them to seek trades that seemingly give them a reward-to-risk ratio of 2:1, 3:1, or even higher.  The reality, however, is that this becomes a losing strategy if the ratio of winning to losing trades is even higher.  The problem is magnified many times over when traders, out of overconfidence from a winning streak, take greater risk--particularly when market volatility has itself expanded.  The increased market movement and greater P/L volatility from the increased size places an emotional magnifying glass on moves against the position, increasing the odds of a bad stop out.

How do you know if you're taking risk that is not psychologically sustainable?  One simple yardstick is to observe your behavior during the life of a trade.  If you have a highly diversified portfolio; if you have  moderately sized positions with wide stops; if you express trades in risk-limited ways with options or relative structures, you should not be hanging on every tick in markets.  If you're glued to screens, if you're constantly checking your phones, if you're unable to conduct market research and attend to your trading business because you're preoccupied with market movement during the life of your trades, you no longer have emotional control.  You are much more likely to make reactive trading decisions that have low odds of success.

Risk taking that is threatening is not emotionally intelligent risk taking.  We cannot control markets, but we can control the risks we take.  When we size positions larger than we can ultimately tolerate given market noise, we give up our control--and that surrenders any edge we may have possessed.

Further Reading:  The Real Reason Traders Trade Emotionally