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Four Steps to Taking Intelligent Trading Risks
By Ari Kiev
In the month of January a lot of hedge fund managers were encountering enormous difficulties. Some complained of being in a "trading funk where nothing worked." Others "couldn't get it right" and lost confidence in their day-to-day decision-making ability. Volatility expanded rapidly during a four-week span, and no one expected the numbers to be as bad as they turned out to be. Some held on stubbornly, refusing to take their positions down, believing that things would turn around. The trades were crowded; some thought that they should have been more aggressive in hedging and should have reduced the size of their positions.
This reminded me of one trader, Everett whom I had talked to a while back, who admitted that he was in some trades that were relatively new for him and he increased his risk by adding to trades that turned out to be different ways of expressing the same bet. Unfortunately, his risk systems weren't really in place. He apparently also took his eye off the ball by getting involved in so many unfamiliar trades and assuming that the macro trades were good.
In fact, his problems had a lot to do with his method of information gathering and the stress he was experiencing as a result of his recent losses. And the lessons he learned could be seen as applying to many traders at the start of 2008. In order to get back on track, traders have to better differentiate the so-called noise from the information available to them and to become more active in the management of positions. At times of high volatility and market downturns, traders have to trade fewer strategies, reduce the size of their relative value trades, become more active in the macro sphere, and become more contrarian. They also need to achieve better risk control by getting out of positions that aren't working. They need to keep moving and not become paralyzed by the price action.
Everett is far from being the only trader with issues about information gathering. The process can be stressful, especially for nonanalytical types. Some people are naturally wired to take extreme risks with insufficient information or thoughtfulness. For these traders, the practice of digging deeper can seem mundane and trigger a variety of anxiety responses. Beyond this, their aversion to analysis and a lack of confidence in their intellectual prowess hamper them, especially at times when things aren't working.
Conversely, traders who become too absorbed with information gathering can also create added stress for themselves. They spend too much time digging in and too little time actually placing the bet. Traders who are obsessed with getting the whole picture right can increase their levels of stress when they gain too much information to adequately process it or use it, or when they postpone action in order to gain more information.
Of course, some traders may come into the process of information gathering already besieged by anxiety, and this anxiety can actually interfere with how they gather and perceive data. As a result they lack the psychological energy to think strategically and to look for original ways of examining the material they collect. For example, they may fail to seek out innovative perspectives that might give them an angle on company change. Stress-ridden traders forget to keep triangulating information -- checking with a variety of sources to prove or disprove a theory, as well as double-checking data to ensure accurate stock judgment.
Other anxious traders lack the patience to gather data points from a variety of perspectives so as to form their own conclusions or make their own decisions. Instead, they may be too quick to act on inadequate information and tend to believe in their ideas rather than developing a skeptical or agnostic view of their analyses. Moreover, they may become too attached to ideas and inclined to be unwilling to be flexible or adaptable in the face of new information and perspectives.
An almost phobic avoidance of stress may keep other traders from stretching to obtain more information or from asking difficult questions, because they are fearful of appearing foolish or wrong. Neglecting information gathering can only lead to more losses, which subsequently only lead to more stress.
Actually, the process of information gathering can be a way of helping reduce anxiety. When a trader is as prepared as he possibly can be and is trading on the basis of reliable information or research, his levels of anxiety should be less than if he were taking a shot in the dark.
To take increased risk in the marketplace requires a combination of understanding the fundamentals and having the courage to trade your convictions. Trading bigger requires more data gathering and processing so as to produce results.
Four Steps to Taking Bigger Risks
1. Create an information edge so that you are ahead of the curve.
2. Have a thesis that you can support with data.
3. Assess the sources of the data.
4. Trade on the basis of this data against others in the marketplace.
The trader who understands risk will pay attention to corporate numbers and guidance and will try to analyze the relevance of these numbers to where the company stands relative to its major competitors. He is also able to differentiate between companies and does not simply trade noise or daily movement.
The best traders focus on the company balance sheet, earnings reports, and an assessment of the growth prospects of the company. They also compare the company on a relative valuation basis to other companies in the same space. They consider the state of the economy and any significant macroeconomic variables, such as Federal Reserve interest rate cuts, the cost of energy, and the cost of doing business, and try to assess the nature of the market at the time.
To improve your data, ask yourself: Is this a market that is trading on fundamentals, or is it trading on macroeconomic variables and market sentiment? Then try to get a handle on relevant short-term catalysts -- fresh earnings news, changes in top executives, new technology, for example -- that may influence the market's perception of the value of a stock. Once you take these steps, you can try to make a calculated bet on the impact this data will have on the price of the stock.
Master traders are likely to factor all these things against their past experience in trading the stock, and may buy or sell some of the stock to get a feel as to how the stock is trading. Here they are also interested in the price action and what that tells them about the supply and demand characteristics of the stock -- how it is trading based on an interest in buying or selling it among other investors and traders.
With all this data analysis, they then try to determine the risk/reward profile of a particular trade in terms of its upside versus the downside of the trade. To the extent that it fits within their parameters (say a 3:1 risk/reward ratio) they enter into the trade, all the time being careful to balance the trade in terms of their net long or short exposure. Oftentimes they hedge a bet by making a comparable trade in the opposite direction or by holding options, which they use to leverage their bet and protect their downside risk.
Ari Kiev, M.D. is a world-renowned psychiatrist and author. Dr. Kiev has authored more than 20 books
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