- 1999: Volume 8, No. 3 The Mind of a Trader: The Progressive Trader and Risk

Risk-taking is older than literature. As far back as 3,500 BC the Mahabharat, the holy scriptures of the world's oldest religion, Hinduism, describes a game of chance played with dice on which kingdoms were wagered. Little wonder then as Peter Bernstein states in Against the Gods, "the modern conception of risk is rooted in the Hindu-Arabic numbering system that reached the West seven to eight hundred years ago."

Dealing with risk is part and parcel of being a trader, and many traders great and small will have their own ideas about risk management. But what precisely is the relationship of the great trader to risk? What would an experienced trader such as Pat Arbor, former chairman of the Chicago Board of Trade-the world's largest derivatives exchange, have to say about risk?

Risk-Why Take It?

"Nobody ever achieved greatness by doing nothing. You have got to step out and do something and take a chance and get your teeth kicked in. A good trader has to engage in some acts which are considered risky," says Arbor.

As Arbor explains, great traders take risks and manage risks. "I think a great trader certainly has to have a psychological stability about themselves, but not too much stability, because one has to have a certain flair for risk. It is a fine psychological blend you have got to look for in a trader; the ability to take risk, the ability to have some courage, coupled with stability in the psychological make-up. I think the great traders have to have a greater appetite for risk than the normal person or the poorer traders. Then the question is how they mange that risk, the discipline they impose on themselves to manage that risk.

"In most cases the risk is balanced. In my own trading, I have always tried to be a spreader or arbitrageur. If I am long one month soybeans then I am generally short another month soybeans. And I generally do soybeans or bond spreads. If I am long bonds then I am short 10 year notes. Sometimes if I am long a commodity outright, then I might be long corn and short soybeans or long soybeansand short corn.

"You also spread because you may not be prepared for the straight position. You may like the position, you may be bullish on the position, and it may not be going well. You would like to maintain your position, possible moderate it a little, by selling something against it. You may be long soybeans outright, and you can neutralize it a little my selling soybean meal, or soybean oil or some corn against it. Your S&P position may not be going so well and you may want to sell bonds against it. You are keeping your position, but cutting your profit potential. Of course, you could just take the loss. But where you may not do that and have a spread instead is where you think you are right and like the position then you tend to neutralize it a little bit to mitigate the loss."

Spreading or hedging as a form of risk management is not necessarily suited to everyone, as Pat Arbor explains.

Finding a Style to Fit

"As a trader you must decide what you are. You are either a speculator, spreader or local scalper. You have to fit into one of those categories. Me I am suited to spreading.

"To find what suits his personality, he just has to see whether or not he makes money at what he's doing. I have had people come into the office, saying, 'I am a great trader,' I say, 'you're right,' they say, 'Know how to trade.' I say again, 'You're right' and the say, 'I predicted that the market was going to go up or down', and I say again, 'You are right. But the bottom line is whether you make any money.'"

So, whilst hedging can be a good way to manage risk, whether or not you wish to be a hedger depends on what trading style makes money for you given the type of trading personality you are.

From Small Acorns: Progressive Trading

Progressive trading is the name I have given to the idea that the best trading results and long-term profitability is assured through a "slow and steady" style of trading. I have yet to meet a great trader that advocates wild risks in order to make spectacular home runs.

As Arbor continues, "the best traders I think are those who try to make a little bit every day. You surely have your success stories; those that hit home runs, but if you take a record or study of the home run hitters against those that try to hit singles every day, the success rate of the former is a lot less than the latter. So a good trader ends up being one who accumulates capital over a period of time.

"I once remember explaining this to a young Italian trader and I said to him, it's una fagiola (one bean) a day. If you try to put one bean in a bag per day then at the end of the month you are going to have 31 beans in the bag. But if you try to put all 31 beans through the mouth of the bag you will spill a few, and in some cases you will not get any of them in. So it is better to build it up one day at a time, in a small manner, slowly. It's tempting not to do that when you see the George Soros's, but if you live by the trading sword, you die by the trading sword."

Implicit in Pat Arbor's advice about "progressive trading" is the idea that it is all right to be out of the market.

"The discipline not to trade, that's a big one. A lot of people don't realize that. A lot of people think you should stand there all day long and be in the market all day long. There are times when the market is so dead or so illiquid that you should not be trading. There are times when the market is terribly volatile and makes no sense and you should not be trading. It is generally the former though. I have seen people stand there all day long when there is nothing going on, just a few locals in the pit. They will put a position on out of boredom. Then they can't get out of it easily. I say to them, 'well, you shouldn't be trading. There's nothing going on. Take it easy. Take a walk. Go off to the coffee shop.'" I think I'll go for a coffee now.

ALPESH B PATEL is the author of The Mind of a Trader: Lessons in Trading Strategy from the World's Best Traders and Trading Online (both Financial Times Pitman Publishing). Alpesh also runs trading seminars-for information, see www.ftmanagement.com/tradingonline.