I've been thinking a lot about risk versus reward these days, especially after reading a little e-book called How to Be a Rogue Trader
by John Gapper. Gapper's book was written with the intention of describing the milieu of financial institutions that, at least to some extent, foster or encourage rogue trading. With former MF Global chief Jon Corzine testifying before the House Financial Services oversight subcommittee as I roughed out this article, the issue of rogue traders and institutions obviously deserves attention.
In addition to detailing the milieu that encourages such rogue traders, Gapper also laid out a profile of a potential rogue trader. That profile was reminiscent of the FBI profiles we see on crime-related television shows. As I read it, I found myself thinking that some elements of that milieu and that profile pertained to us retail traders, too.
Gapper relates that the right milieu for a rogue trader exists at institutions that might be attempting to refashion themselves into global investment banks "that could take on the likes of Goldman Sachs on Wall Street" (Location 294 of 778). Such institutions might not have appropriate back-office staffing or risk-management procedures in place. They might be attempting to move into areas in which they didn't understand the risks or perhaps even be deliberately accepting unhealthy amounts of risk in order to catch up with the bigger firms.
The rogue trader himself--and, so far, Gapper notes, they've all been male--might have some image problems, too, that prompt him to play catch up to other traders. Gapper includes the warning risk consultant Chase Cooper sent bank clients, with the warning authored by Nick Gibson (Location 510 of 778). Gibson warned clients to be on the lookout for "a likeable twenty-eight-year-old male index derivatives trader who has been promoted to the trading floor" (location 512 of 778). This would be especially important if he'd been promoted from the back- or middle-office systems, so that he would understand the inherent problems in a bank's risk-management procedures. Is there something in this man's background that lead him to believe he's an outsider in the setting in which he now finds himself?
This should be an intelligent person from a good but not prestigious university. The trader would have the ability to hide mistakes and the need to prove himself more worthy than his compatriots who perhaps graduated from more prestigious universities.
He might begin by making "small bets on index and securities futures" (location 516). He would perhaps pretend to hedge these fictitious trades. Gibson warned that if such a person existed, he might have "hidden . . . an unrealized trading loss of about $2 billion" when his actions are finally discovered in about three years' time (location 517). The majority of those losses would have occurred in the last few days, when he was increasingly desperate to make back ever larger losses.
Other characteristics include a trader who never takes vacations, gets belligerent with underlings who question the risks he's taking while maintaining a charismatic demeanor to his superiors. Is he making beaucoup money, so much that no one dares question him too much, because his so-called earnings have become important to the firm? He might be trading such complex trades or trades on such illiquid securities that he's the only one who seemingly understands what he is doing or who can provide a price for the securities. Gapper goes on to describe how these traders are able, for a time, to hide the risks they're taking. They might enter equal and opposite trades in the computers and then cancel them during the window between when trades are registered in the front office and then confirmed in the back office.
Most chilling is "a sixth, mysterious, [SIC] flaw. When they get themselves in trouble and have gambled their way into such a deep hole that it is almost impossible for them to get out, they do not stop. They carry on until they are either caught, [SIC] or the loss rises to a disastrous level" (location 594). Once the loss rises to those disastrous levels, they describe panic attacks, periods when they stared at the screens for extended periods, nights without sleep, days without meals.
Gapper describes experiments related to gambling behavior, experiments conducted with animal and human participants. Some of the animal experiments used food to test the gambling behaviors. The animals were risk averse as long as they were assured of getting adequate food no matter which choice they made. If starved, however, and if the safe choice was no longer going to provide enough nutrition, their behavior changed. They stopped choosing the sure thing and went for the dish that half the time provided nothing and the other half, double the usual amounts of food. If the odds were on their side, they would survive. The other two outcomes--choosing the "sure thing" dish and choosing the other and having it come up empty too many times in a row--would result in continued starvation. (Let's hope they didn't let the poor birds die.)
Decades of research have revealed that most of us are risk averse, too, but there is a point at which fear of risk flips over into fear of loss. That's the point at which our brains switch from intellectual choices to instinctive ones, and the instinctive one is to take the bigger bet. As far back as 1738, Swiss mathematician Daniel Bernoulli concluded that as long as people had enough to survive, they were risk averse. More than two centuries later, in 1979, Israeli researchers Daniel Kahneman and Amos Tversky detailed the point at which humans switched from risk averse to loss averse and began gambling. They made the switch when they had a chance of exchanging a "definite loss for a 50 percent chance of escaping unscathed" (Location 229).
Just stop here a second and think about that. How many times are options traders at that point: the point when they can exchange a definite loss for a chance of escaping unscathed?
However, not all people at that point go rogue. The overriding trait of those who switch to loss aversion and choose the gamble "is their inability to accept loss: they struggle instinctively--irrationally, in economic terms--to evade it" (Location 234). The research concluded that any theory--or trading plan, I would suggest--that "ignores feelings such as the pain of losses and the regret of mistakes is . . . unrealistic" (Location 735).
Why did I find this book so chilling? I think the precepts outlined in this book could easily apply to those of us trading in our offices on our desktops or elsewhere on our laptops. I've heard tales of panic attacks, missed meals and no sleep from many other traders. While I haven't experienced panic attacks, I've spent many a sleepless night trying to figure out adjustments.
Here's the deal. Trading independently, we're both the institution and the rogue trader, the birds in the non-human experiment and the humans in Bernoulli's, Kahneman's and Tversky's experiments. Have you recently switched from trading occasionally for fun to trading full time? Then you're the institution that may not yet have the proper risk-management procedures down pat. If you're suddenly dependent on the money you earn, you're also the birds in that experiment, the ones who can't survive unless they gamble. You're at risk of going rogue.
Have you found yourself in a loss bigger than you can afford to take? You've likely made the switch from risk averse into an all-governing fear of loss. By definition, if you're facing a loss bigger than you can afford to lose, you're in that state, and you need to talk to someone. You're not thinking clearly. You're definitely at risk of being the trader who goes rogue, compounding losses unless Lady Luck just happens to be on your side. You can go rogue because there is no back-office staff to question your risks. You don't even have to bother to hide the risks you're taking, in most cases, because the people around you might not trade and might not understand the risks.
If there is a spouse or trading partner looking over your shoulder, it's easy enough to unclick a trade or add a simulated one that covers up the losses. You can offer an obfuscated description of your trade setup that will confuse a non-trading spouse, or choose a vehicle or strategy too complex for your trading partner to understand. In case you're wondering, no, I haven't done any of these. I'm the person who will drive--and has in fact driven--across town to return a pen that I accidently dropped into my purse after signing a charge slip. In the past, before I had a trading group, I would describe ad nauseum to my husband what I was doing until he would practically be crying uncle. However, that doesn't make me immune.
And I've seen or talked to others that I suspected were going rogue, although I didn't think of them with that specific term at the time. I've been in a gathering in which I questioned the risk an acquaintance was taking on and been angrily told of that trader's research and conclusions about the trade. I've seen that trader suffer terrible losses when the risks proved to be more than that trader had anticipated ever taking. The profile that Gapper included sounds all too familiar when I think back over those exchanges with someone in a trading group.
I've been the person missing meals and sleep. I don't for a moment believe that just because no rogue trader has yet been female that there will never be a female rogue trader. But I do know, ahem, that males have a reputation for not wanting to ask for help and that some women at least are more willing to ask for help. I know that when a loss I had was greater than I wanted to take, I called someone, someone trusted, who told me, "Just get out, Linda." And I did. I don't think I, as a female, lack that sixth, mysterious flaw that drives rogue traders to keep going and not stop. I think it's that I am still willing to admit when I'm in trouble and ask for help, and take that help.
So, maybe that does mean that this particular female doesn't have that sixth, mysterious flaw. So far. Or maybe it's that I'm so far from twenty-eight that I am not prone to going rogue. Although I have not gone rogue, I know I've felt those feelings and almost anyone in a losing trade has done so. We can't divorce feelings from our trading. I disagree with all the warnings that our trades must become automatic, divorced from emotion, because I don't think that's possible. I think we have to acknowledge that there's going to be emotion and put in safeguards to keep that emotion from pushing us into rogue behavior. Gapper and others say that when we ignore the impact of feelings, we risk allowing rogue trading, either in ourselves or others.
I've talked lately about risk analysis charts such as those on Options Oracle and brokerage platforms. Those charts show the maximum loss and gain for a trade and many offer a "today" line that shows where the profit or loss is that day, and where it can go that day. Excel spreadsheets and PnL statements on brokerage platforms can show the accumulated gains or losses in a trade. Dan Sheridan, who often presents webinars on CBOE, counsels that traders pull their spouses, trading partners or friends into their offices and show them how the trade is set up and where it is on that day. Ask your wife, Sheridan says, whether she's comfortable with the shape of that "today" line and see what she says. My husband is not a bit interested, so I show my trades regularly to other traders who are familiar with my type of trades. I can't fool those other traders because they know how to interpret such graphs.
If you've recently begun trading or have recently switched from a part-time, for-fun or lottery-type trades to "I'm going to make a living at this" trades, realize you're at risk of making that switch from risk aversion to fear of loss. Put safeguards in effect so that you can't go rogue.