- 1999: Volume 8, No. 4 The Mind of a Trader: Risk Aversion: Risk Not Thine Own Wad

Trading is about risk. Risk can be bought and sold like any other commodity. Derivatives are one instrument through which risk is transferred. The great trader has a deep understanding of the nature of risk, but perhaps most surprisingly, is risk-averse; he takes out insurance against being wrong. Moreover, he balances risk with his own personality to produce a harmony between the two; never being so exposed as to feel uncomfortable and let it affect his trading.

Six feet tall, a muscular physique and bald save for a pony tail-that is Jon Najarian by appearance. In 1989, Jon Najarian formed Mercury Trading, a designated rimary marketmaker, responsible for maintaining a market in stocks for which it had been designated. Two years later, it reported a return on capital of 415 percent. Today it is the second most active market-maker on the CBOE.

A highly profitable trader, I wanted to know how he would advise other traders about risk.

Perceptions of Trading Risks

As Najarian explains, "I am very risk averse. You have probably seen on peoples' walls, 'risk not thine whole wad.' We always try to position ourselves so that we can always trade tomorrow. That is the single most important thing. Not making money today, making money today is not more important than being able to come back tomorrow. If I want to be short the market, because I think they are going to raise rates and that will pressure the market, will I be naked short? No, we are long puts and every day that goes by and the market drops, we buy a ton of calls so that if the market turns and goes up we do not lose all the money that we made by being right. You only get so many times a year to be right. But we always want to lock in the profits so we are constantly rolling down our hedge and never just one way long or short.

"Many days when placing a spread or a hedge, we think 'god, if someone had tied me up in a closet we would have made a fortune,' because as the stock was falling we were taking profits all the way down. Well, that is just the curse of being a hedger. It is also the reason why we sleep the way we sleep every night."

Because Jon Najarian knows he has disaster protection insurance, he can be more at ease.

"When you come in after a weekend where the market was down 148 points, it looks ugly-they were having trouble finding buyers all day, then if I am stuck in a position I could be very panicked. But we sleep like babies."

Any Temptation To Go for Home Runs?

It is comforting to know that the top traders have the same bad trading temptations as the rest of us.

"Sure there are times when we wished that we were not as disciplined. But more times than not we were glad that we were disciplined. We see so many people bet for home runs by putting all their marbles on a big shot. When we bet on a big move we do it with a controlled amount of risk even though we are betting for a home run. We are buying a lot of out-of-the money puts and we are selling out-of-the money puts as well as a hedge against the puts we are buying. If we say we are buying some puts for $4 and selling other puts for $2 then we only have $2 worth of risk. So I can stay at the table twice as long. The other guy, who is unhedged, is starting to gag when the market is going against him, but we can stay with the trade longer."

Since the hedge provides Jon Najarian with a comfort zone, he can be free to exercise clearer judgment. Imagine the last time you were panicked by an adverse price move. Did it ruin your day? Did it plague your mind? Did it affect other trading decisions? If so, have you considered hedging you position? You will of course have to examine the cost elements of hedging and the extent you may wish to be hedged. Risk is a beautiful thing, with ingenuity you can purchase or sell just the precise amount of risk.

"The other thing we look at is the buyers and sellers. Again on the derivatives side we see Salomon, Morgan Stanley, Lehman, NatWest buying, buying, buying a certain stock and we know they are betting on the upside, too. So we are reading all these tea leaves as well. We see that the chart pattern looks good, institutional buyers are coming in-is there anything in the news? Are earnings coming up? Has anybody commented on it favorably? Is there a new product coming out? Is there a lawsuit pending? We look at all those things so that by the time we actually place the bet we probably have a huge edge because of all those factors we looked at, that our winning percentage is off the charts. Most people do not have the benefit of seeing all that information so what they have to do is give themselves the chance of being as right as possible."

It follows from this, that when Jon Najarian does enter a trade he wants the upside to be far greater than the downside, even if the downside move is highly improbable.

"The worst I do is a 1:1 risk-reward ratio. Most of the time I want a 2:1 or 3:1 reward-to-risk ratio. So if I think it could go to $35 then I sell at a loss, if I am wrong at $29 or $28 so that I have a multiple risk reward ratio on the upside. If I am wrong I cut the trade and move on."

"You cannot be willing to say I am going to ride this stock down to $20 if I am wrong, but I am going to make $5 if I am right. If you do that kind of thing, you are just not going to be in business very long."

"I would never put a multiplier on the risk to the downside. I would never say that although there is $5 on the upside, I am so confident that I am willing to take a $10 risk to the downside. It would not be acceptable risk."

Few people would associate such a risk-averse, belt and braces approach, with a trader, let alone a great trader. However, risk aversion and caution are the hallmarks of great traders. While many of us may have a strong appreciation of this, it can never hurt to be reminded.

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 acts as consultant on strategy and new market entry to some of the world's largest online brokers. He can be reached via www.ftmanagement.com/tradingonline and alpesh-patel@msn.com.