- 1999: Volume 8, No. 1 Risk & Money Management: A Primer From a Leading Trader

As part of my endeavors to discover the traits of the leading traders in the world and what they can teach the rest of us, I interviewed Bernard Oppetit, Global Head of Equity Derivatives at Paribas. This part of the interview focuses on risk and money management-two essential components to trading success.

Paribas, part of Groupe Paribas, is an international wholesale bank with a presence in more than 60 countries. Groupe Paribas has total assets exceeding $269 billion. The Global Head of Equity Derivatives at Paribas is Bernard Oppetit. A slim, tall and pensive Frenchman.

Bernard Oppetit deals mainly with equity derivatives, options and index options, in all developed markets and a selected number of emerging markets such as Brazil, Argentina, Mexico, most of South East Asia and now Hungary, and Poland. He specializes in risk arbitrage, which involves trading stocks which are likely to be active due to special situations such as litigation, etc.

However, what Oppetit has to teach on trading applies to all instruments.

Great Traders Tend to be Risk-averse

The public perception of traders, propagated by trading scandals, is that they are attracted to wild risks and take massive gambles. Of all the traders I interviewed, not one claimed to be risk-loving.

Oppetit details the contrary view, "I am very risk-averse. I would definitely take the certainty of making $10,000 dollars than the 10 percent chance of making $100,000. In terms of economics, my personal utility function is very much concave."

When we speak of risk in trading we are of course discussing price volatility. Price volatility cannot be discussed without an idea of probability. The probability of a stock's price reaching your target can be derived from the historic price volatility of the particular stock. Consequently risk, price volatility and probability go hand in hand. Good traders wait until the probability of a favorable move is the greatest and the risk of an unfavorable move the lowest. Moreover, unlike non-professional traders, the great trader knows that risk and reward are not always directly proportional. There are very low risk and yet high reward trades.

Oppetit continues, "The important thing is to look at risk in a rational way, and an imaginative way. A good trader knows how and when to take risk and how and when to avoid risk. There are risks which should be taken and risks which should not be taken. The game is to distinguish between the two. You do not need to risk a lot to profit a lot. There are a lot of trades where you can make a lot of money which are not particularly risky. You may have to invest a lot of your time to do research and discover what is going on, but the actual money you invest may not be at much risk.

"There is a joke about an economics professor who is walking in New York with a friend. His friend notices a $100 bill on the sidewalk and points to the bill and says, 'look professor, a $100 bill.' The economics professor replies, 'no that can not be so, if that was a $100 bill somebody would have picked it up already.' Still I believe there are opportunities to make money with very little risk."

Analyzing Risk and Probability

So, how does Bernard Oppetit analyze risk and probability when he examines a position?

"Even though I know I will get out after a certain loss, I consider the amount I have risked as the whole amount invested. Also I look to see what percentage probability there is of a certain percentage rise and I compare that to the risk I am taking. I would look at some kind of distribution of possible outcomes, Such as a 50 percent chance of doing something special or a 50 percent chance of doing nothing in particular, or a 50 percent chance of a small loss against a 50 percent chance of a great gain. There has to be some idea of the distribution of outcomes."

What Bernard Oppetit does when analyzing a potential trade is to consider at risk the whole amount he is trading with. This is even if he knows that he will exit the position if the price falls by, say, 15 percent and therefore he would only risk losing 15 per cent of his stake.

He then examines the reward. He measures reward by examining the probabilities of various outcomes. One can only gain an idea of the reward if one examines the probability of it occurring.

Bernard Oppetit would then compare the risk with the reward. For instance, an options position opened with $10,000, would place $10,000 at risk. To get an idea of his risk and reward ratio, Bernard Oppetit would then examine the likely outcomes and their probabilities. This would give him some idea of the reward he may get for the risk he is taking. (If he were being very mathematical he would sum the products of all the outcomes and their corresponding probabilities, and compare this figure to the amount risked.)

Money Management

Good risk analysis and management is not only about volatility and probability, it is also about good money management.

As Oppetit explains, "You have to have good money management. You have to ensure you are not going to be hopelessly underwater. You can have rules like maximum drawdown or value at risk or limits. You can also have your own internal rules like "this is too much money to lose." You must have that in your mind and that you are not going to risk more than that at any one time. You have to make sure you are left in the game. That is very important. Once this is clearly established you need fear; you need to feel that things can very quickly go wrong."

In devising a money management plan, you would consider the following:

• What is the most money I will risk on any single trade at any one time, i.e. what is too much to be lost?
• What amount must I avoid losing on a trade, given that I might lose on a consecutive number of trades, so that I do not become in serious danger of being out of the game?
• Once in the trade what is the maximum percentage I am prepared to lose before exiting? Some decide this based on "value at risk" i.e. a mathematical calculation based upon the probabilities of various outcomes of all open positions, and hence the value of money at risk.

Facing a Loss

When sitting on a paper loss a trader will indubitably experience immense pressure and fear.

Oppetit continues, "It is very important to experience this fear to ensure you do not end up in that situation again. Fear is also a bad thing in that it will affect your judgment, in the same way elation would affect your judgment. You have to take a very neutral approach."

So, experience the fear when faced with a loss, do not deny it. But use the fear as a means of loss-prevention in the future, not as a cause of ever increasing losses. When looking at a new price you do not focus on the fear of how much you have lost, or the hope it may turn around.

"You have to ask if you are a buyer at this new price. If you didn't own it already would you buy it? If the answer is no then I sell it. You have to look at the position with an open mind and ask if you would put it on today if you did not already have it. If new information came in while I had an open position, I would change my expectations. But you have to be honest with yourself. It is a question of attitude. It is an easy trap to fall into to kid yourself that you are holding on to something because you believe things have changed and it will now rise. It comes back to being honest with yourself."

Handling a Profit

As well as hope, another damaging emotion surrounding open positions which prevents an honest analysis, is that an unrealized profit may vanish.

"It is a clichŽ that you cut your losers and ride your winners-but it is very true. Most people and many traders do the opposite. There is a desire to take profits, sometimes encouraged by accounting rules. Many people look at their unrealized gains as non-existent. They think taking profit is making real profit and it is unreal before then. They feel taking a loss is an admission of being wrong."

Again, this emotional attitude to profits has to be eradicated.

Instead of focusing on whether he was right or wrong, Bernard Oppetit focuses on his expectations regarding a position, in order to maintain objectivity.

"If what I had expected to happen does not happen then I know to get out. Whether I get out at a profit or loss does not matter. As soon as I realize my scenario was wrong I get out. Another easy case is when everything I expected happened, so I take my profits. Those are the two easy cases, and everything in between is difficult."

What Bernard Oppetit is discussing is that all open positions have to be viewed objectively. That means you have to focus on certain questions and reasons and ignore others.

You need to focus on:

• Has what you expected to happen, happened?
• Are you a buyer or a seller at this price?
• Is the probability of what you expected to occur still the same as when you placed the trade?

You have to ignore:

• How much of a loss you are sitting on;
• How much of a profit you are sitting on;
• How much you paid for the position;
• Hope that the position may turn around.

Conclusion

The aim of this article is to provide a taste for some of the issues involved in successful trading that have little to do with fundamental and technical analysis. Money and risk management apply to all forms of trading irrespective of product or method of analysis.

Management of one's trading positions requires the discipline to plan for contingencies and ensure a strict mental discipline to ensure positions which are too risky are simply not entered into. A degree of mental or psychological control is also required, and an awareness of common pitfalls, if one is to be able to execute effectively risk and money management plans.

Alpesh B Patel is an attorney turned trader and the author of The Mind of a Trader: Lessons in Trading Strategy from the World's Leading Traders (Financial Times Pitman Publishing 1998). He operates his own derivatives fund concentrating on traded equity options. He has extensive experience in both the U.K. and U.S. derivatives markets and holds equities in the U.K., India, France and the U.S. As a former chairman of the University of London Finance Society, he has lectured extensively on trading techniques. He can be reached by e-mail at alpesh-patel@msn.com