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Keeping Risk At Arm’s Length

Keeping Risk At Arm’s Length
November 15
00:32 2011

Two traders sitting at neighboring desks, trading the same asset with the same financial instrument, the same trading software, and even the same type of trading program could each choose very different price levels to enter and exit their trades. That’s because the individual motivations for each trader – their taste for reward and their ability to withstand risk – can be so different.

In the investment world, we call a trader’s preference to limit losses “risk aversion.” It is part of an individual’s overall “risk profile,” i.e. the degree to which risks are important to that individual. Risks to bodily health and safety are less important to a skydiver or a bullfighter than they are to a jogger, for instance, and so too with trading. We all have a unique point that represents how much risk we are willing to stand. It can be represented on a chart, where increasing monetary values are represented on the x axis, and the risk of losing value is charted on the y axis. Where would you mark your risk profile on that chart? If you aggressively seek very high returns and are willing to withstand some large losses in the pursuit of those returns, your risk profile would be in the top right-hand side of the chart. If you prefer the relative safety of lower, more certain returns with less risk of losing capital, your risk profile would be charted on the bottom left-hand side of the chart.

Traders whose risk profile is weighted toward safer but smaller returns show risk aversion. Risk averse traders see more appeal in blue chip stocks with steady dividends, for instance, than small-cap pharmaceutical stocks which may or may not ever bring a profitable product to market. They might also be more likely to be buyers of options (with no obligation to lose money beyond the initial premium) than sellers of options. Basically, risk averse traders have a preference for minimizing the magnitude of the worst possible outcome for any trade, rather than maximizing the magnitude of the best possible outcome.

It’s very important that you spend some time evaluating your own personal risk profile and determine how risk averse you are. If you find that your trading program doesn’t accurately reflect your tolerance for risk – perhaps it has left you too exposed to systemic risk or perhaps it doesn’t pursue returns aggressively enough – you should certainly make changes to limit your risk of overall loss or maximize your potential returns for the given amount of risk you are willing to withstand.

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It’s best to approach these changes on a whole portfolio basis, rather than with each individual trade. Although one individual position may be very risky on its own, taken together with other, safer, simultaneous trades, your overall risk of loss at any point in time may still be within the boundaries of your own risk profile.

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