Saturday, May 23, 2015

Intellect, theory, risk taking and reality

From the outside, trading opportunities within the big financial institutions or investment banks seem to be a closed shop. I took a look at job opportunities in the City of London this morning and all of them seemed to want people who were educated to a degree level, and/or who already worked in a financial institution. This obviously rules out bozo's like me, who left school and didn't proceed into further education, or who have never worked within the industry.

This fixation with having a high level of intellect can be dangerous. It seems to me that, even with the supposed brightest minds working for them, things can and do go spectacularly wrong.

Perhaps the most (in)famous failure of intellect was Long Term Capital Management. They had a former head of the Federal Reserve. They had not one, but two Nobel prize winners who created the Black-Scholes options pricing model. Yet they still racked up massive losses when things out of their control occurred before LTCM got bailed out.

Why do these kind of events happen?
  • There is a world of difference between theory and what happens in the real world;
  • A failure to respect risk;
  • A failure to take a small loss when they had the opportunity, which then developed into a far greater loss.
Having spoken to a few people who have worked in the City, it is my belief that, within a number of these financial institutions, there are traders taking big risks, and the risk managers turn a blind eye providing they are bringing in the bumper profits. 

Of course, every so often stories come out about those same traders causing huge losses. Those same risk managers who turned a blind eye, or who overrode or ignored risk controls when things were going their way, now hung them out to dry, the news comes out in the public domain, people lose their jobs, firms can go bust or suffer big losses, and generally the whole episode gives traders (and trading) a bad name. Think Nick Leeson, the London Whale, Jerome Kerviel, Kweku Adoboli and others for starters.

One would assume that, given the education or intellectual criteria these institutions use, these traders were degree-educated or similar. They had people of comparable levels of intellect alongside them as trading assistants, risk managers, along with an army of programmers who may well have created trading algorithms and sophisticated risk management protocols. And yet they all blew up or created huge losses in spectacular fashion.

I'm told that these type of institutions often use Value at Risk (VAR) models and are pushing the probabilities of how much risk they can take. Whether this would change if the big investment banks ring-fenced capital from their retail operations separately from the investment side is anyone's guess. If the current proposals here in the UK ever get enacted, then they won't be able to siphon off money from the retail side when the investment arm makes losses - at least, that's the theory.

Whether the supposed intellect or the ego of the people involved in such cases got in the way of making cold blooded, objective decisions we don't know. Is there a case of "The market is wrong - I will be proven right"?

Who do you think would be the more successful trader - someone who is degree-educated and full of economic theory with an ego to match, or Joe Public who is able to control his risk and emotions?

In the Leeson case, he got stuck on the wrong side of a price trend on the Japanese Nikkei, and kept averaging down his position. And, as price continued down, his losses continued to grow. The end result was that Barings Bank went under.

Even at a lower level, there is a distinct lack of appreciation of the three points listed above - particularly when it comes to controlling risk. There are some traders who push the boat out - they want to control the upside, without having any regard to the potential downside. Good traders strictly control the downside, and place no control on the potential upside. They know they can only control what they can control - their risk and position limits, use of stops, and their emotions.

A trader I used to mentor got an interview with a prop trading firm in London a while ago. Basically he found out was he was way ahead of the curve - he had good risk control and discipline, and they had very little - they were pre-occupied with achieving a certain level of profits each month, almost regardless of the risk. And if you didn't make the required level of profits, then you were out of the door. And the head people at this prop firm had all worked for the big financial institutions.

Given that, I guess its no surprise that quite a high proportion of prop firms who have this approach spring up and then quickly disappear. I'm sure not all such firms are the same, but it is frightening that some are set up in this manner, run by people with a supposed financial institution background and a high level of intellect.

So, as you wouldn't get a reload of your capital from a superior or another part of your business, or get a government to bail you out, what can you learn from all this? Some thoughts to ingrain in your mind:
  • Never take your eye off the ball in terms of risk control and position size;
  • Don't go chasing big profits;
  • Learn to accept (particularly if trend following) that you will have more losing trades than winners, and that win rate on its own will not determine if you are profitable or not;
  • The simplest way to avoid big losses is to take small losses;
  • Never average down on a position (As Paul Tudor Jones says, losers average losers);
  • Focus on your process, not the outcome;
  • Never let your ego or emotions get in the way of accepting you are wrong on a position;
  • Never believe that you are right, and the market is wrong - price and your profit or loss will tell you;
  • Be aware there is always the potential for unexpected events or price moves within the markets, and factor this into your trading and risk management plan.
Boring advice, I know. But, it will keep you in game.

1 comment:

  1. Thanks Steve, excellent article. What is most important in this game is risk management, consistency and longevity.