Accepting Risk

Friday, the Indian market jumped up, taking nobody by surprise because the EU heads had unanimously decided to support Greece. If you want some more reasons we can reasonably add the fall in oil prices. I could add a few more but that would tax my mind and I am in no mood to do it specially when I-for the first time-have something serious to say later on in the note.

First, let me tell you what my system has done. STT became a BUY above 5393. LTT remains a SELL and I will cut my short and go long only above 5610. In the meanwhile if Nifty futures falls below 5306 then STT turns from BUY in to a SELL and therefore I will cut my STT long positions and go short at those levels. You all know that Euro and S&P fell in the evening on Friday and therefore I am worried a bit about my STT longs. But system is to be followed so I will wait for either 5306 to be broken or 5610 to be crossed to do anything. Since both are far away, I fear another day of doing nothing for me! 

Now, to come to the point of this note. Uncertainty/Risk. Uncertainty is essentially always about an outcome and therefore it is synonymous with risk. Uncertainity is feared and therefore almost universally hated, The big problem about hating something is that one wants to get rid of it. A lot of time is therefore spent in efforts to increase knowledge and somehow reduce uncertainity of an outcome or risk of any particular action. My contention is that this effort to reduce uncertainty actually results in potentially catastrophic consequences.

The key I think is to understand the difference between trying to reduce risk and trying to mitigate the consequences of TAKING risk. The first implies a fear of risk and an effort to reduce it. The second implies an acceptance of risk. This difference in not insignificant. For eg, LTCM was as a result of the first. This effort to reduce risk by taking so called uncorrelated trades, making spread bets on same assets, or buying high yield debt and selling low yields finally resulted in disaster. The reduced risk was only a mirage. This belief in risk reduction allowed LTCM to go for high leverage which almost unravelled the financial system. In contrast, an acceptance of risk would imply that all efforts at reducing risk are ephemeral and therefore the only way out is to reduce the consequences of taking risk by reducing leverage or taking very low leverage. While the 2008 crash has been blamed on various things including indiscriminate lending etc, the problem would not have been as disastrous but for the fact that S&P and Moody believed that financial engineering had reduced risks in the CDOs and rated them as AAA. This belief in the fact that risk had been reduced or eliminated is what allowed high leverage and the consequent well documented disaster.

In trading, efforts to reduce risk results in pair trades, statistical arbitrage trades, volatility arbitrage trades, spread trades, convertible bond arbitrage, merger arbitrage and many such trades, all of which make sense only when large leverage is taken. It also results in an almost pathological hatred for directional trading because in that strategy the risk is in your face and cannot be avoided-only mitigated with low or no leverage. Somehow the former seems far more appealing to the world at large given the pleothra of trading desks which employ the former strategies. Almost always, however, the big blowups and flameouts have always come from trading desks which have employed the so called low risk low delta strategies.

Let me give some other examples from other spheres. In movies, trying to reduce risk propogates the star system, overblown budgets, low focus on scripts and similar story lines as producers go for films and actors that have worked in the past. In contrast, trying to accept risk and mitigate the consequences of risk would force producers to focus on strong sripts, a different angle, an appropriate budget and willingness to bet on new actors. No points for guessing which of the two paths leads to rejuvenation and growth of an industry.

Efforts to reduce risk led to the Titanic. Yes, it was a ship of such engineering marvel that the makers actually thought that it was unsinkable. The consequent non acceptance of risk led to the lack of life boats on from what we now know an eminently sinkable ship. The one industry that has accepted risk completely is the aeroplane manufacturers. It is only because they accept the risk that they are able to justify building redundancies for every part/process in the plane. If somehow the industry starts believing that their effort to reduce risk has led to unfailable parts, I am sure flight accidents will increase.

Again no points for guessing what my trading style is. My trading book is completely directional where no effort is made to reduce risk. I just do not leverage. Consequently, I am either long or short on the Nifty, almost all the time. Currently my positions are like this:

STT Long. Will cut long positions and go short < 5306

LTT Short. Will cut short positions and go long > 5610.