In trading there is a very special distinction between the real risk a trading strategy or setup entails and what YOU perceive this risk level to be. When we start using a given trading setup and when we judge its trading results we create a perception of risk which may not be aligned with the actual inherent risks of the strategies we are using. This “break” between what is real and perceived is a major cause of failure for both retail traders and large financial institutions. Through this post I will talk a little bit about the perceived and real risks of trading and what measures are necessary to make sure that your perception of risk is as close as possible to the realistic risk level of your trading setup.
In the period from 2002 to 2008 the world’s largest financial institutions created a derivative market around mortgage backed securities which packaged loans in order to resell them to investors all around the world. For the first time in the history of the world the agreement to borrow and pay was no longer between the lender and the debt carrying person but between the borrower and potentially many different investors around the planet. For the first time ever the lender could give money away without facing the risk of default from its clients. Large financial institutions thought they had found the “holy grail” of trading, a way of making money with reduced risk and larger profit potential.
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However, in reality their perception of risk did not align with the realistic risk behind what they were doing. They were being driven by greed and they didn’t see that what they were doing was simply the inflation of a massive credit and housing bubble which would explode on their faces with consequences for people all around the world. The lack of understanding – or willingness to understand – the underlying risks of what was being done because of short term positive results led to an almost catastrophic failure of the world financial system. What happened was simply that a certain market exposure was taken and when the market came for “pay back” the payback was simply too big. As Lehman Brothers showed, even the “big guys” can wipe their accounts when they do not adequately gauge their market exposure.
I wanted to talk about this so that you realize that risk perception is not only a problem for the retail trader. Risk perception and market exposure assessment is not only important to you as a small forex or stock retail trader but it is important for ANYONE who wants to play a role – no matter how big or small – on the market. Being able to adequately judge the risk of what you’re trading beyond short term profitable results and greed is definitely something which needs to be done if you want to succeed in trading.
Many people will do a certain analysis and get extremely good results with gigantic AMR to Max draw down ratios or they will be amazed at the absolutely marvelous results of a system during a short term period of time and trade the intended setup without the slightest consideration of possible failure. In trading the most important thing you need to have is a perception of risk which is as close to reality as it could possibly be. This not only means to carry out reliable long term back-tests and Monte Carlo simulations but it involves a careful study of the limitations of these methods and the possibilities of risk underestimation within them. Although having a worst case scenario derived from a Monte carlo analysis is a great place to start it is also important to gauge projected risk such that any possible unkowing underestimations are taken into account.
For example we see within audited currency traders that the long term (10-20 year) market cap for the average compounded yearly profit to maximum draw down ratio seems to be around 4. This means that for every value above this level we see in simulations we should be tremendously suspicious as we could be having some underestimation of risk – which can often be unknown – that gives us a result which will not be reproducible in live trading. Most new traders are very willing to ignore these facts and believe they have found “something special” – which is naive – while more experienced traders would instead consider that their inherent risk is at the very least the same as that of the best market performers. This means that a careful trader would reduce their risk such that a WC scenario considering the above “maximum real performer ratio” would yield an acceptable value. For example if an AMR to Max DD ratio of 8 was obtained, the trader would reduce the risk such that 2 times the worst case scenario from MC simulations would be the desired “stop trading” level.
Of course, as long as traders have adequate Monte carlo derived worst case scenarios both will most likely survive in the long term but the second trader – who is much more careful about the realistic aspects of returns – will most probably need to cycle less through systems and portfolios since he or she is considering that simulations that yield very high profitabilities have some inherent flaws which may not be easily recognized. That said, if after running the setups for 5-10 years the second trader decides that the analysis was indeed right and “something very good” has been found then the risk can always be increased.
The important thing to recognize here is that a conservative trader always focuses on having the highest chance of having a real perception of risk – even at the cost of profit if he or she is wrong – while traders who are less conservative care more about expected profits rather than having a realistic perception of their risk within the market, so they are willing to risk more at the cost of potentially more losses due to system failures due to some inherent underestimation in their market exposure. The first trader is attempting to “ground his expectations” while the second trader is building a dream at the potential cost of future losses. The best approach in my mind – without a doubt – is to always try to have an expectation of risk which is as close or worse than the real one, even if this implies a reduction in profits in the long term (survival comes first).
Certainly the important thing here is to remember that one thing is the real risk of what you’re doing and another very different one is the perceived risk you have. If you are trading a system with an expected profit to draw down ratio above top market participants then you are most likely greatly underestimating your risk. This does not mean you shouldn’t do it but you should realize that you will potentially hit your Monte Carlo worst case targets more frequently as you might encounter several factors for which simulations didn’t account for in real trading. In the end it is a choice between trading conservatively or aggressively but in the end what matters is to fully understand and comprehend the consequences of trading in either way. Trading assuming that you’re always underestimating risk a sure way to increase your chances of survival – at the cost of future potential profits – while trading aggressively does the opposite thing. However ALWAYS understand the chances of your risk perception being in line with reality, believing your perceptions are in fact a reality without taking into account all possible underestimations – even ones you may not know about – is a BIG mistake that leads traders, small and big, into wiping avenue. Remember that there is no magic bullet to perform 100 times better than top market participants :o)
If you would like to learn more about my work in automated trading and how you too can learn how to obtain Monte Carlo simulations and worst case targets for your systems please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)
