Risks Peculiar to Trading

Having examined the other ways of making money with money, our next logical step on the road to developing a successful methodology for trading must be to examine its comparative risk profile. The trader encounters the
same types of risk as do the banker, the bookie, and the gambler, but risk operates rather differently for the trader. Certain types of risk are present in trading that are only sometimes or not at all to be found in the other worlds
of making money with money. The first of these, which every trader encounters,is contest risk.

When you or I enter a trade, we must expend a bit of capital in the form of a brokerage commission, much as the poker player must ante up before contesting the next hand. Commission costs, though,are only a portion of contest risk, and not infrequently the least portion.There is a good deal more to the notion of contest risk.In terms of pricing, the trader’s markets aren’t like retail markets such as Armani, Bloomingdale’s, Wal-Mart, or McDonald’s.

If the price tag at Bloomie’s reads $399.50, then that’s what we’ll have to pay for the jacket or the chair or whatever (at least, that’s what we’ll pay today—the item might be on sale tomorrow), no choice and no haggling. In retail America, the seller quotes a single price. If we want the goods, we pay the stated figure, and that’s the end of the discussion almost all the time. Historically, this state of affairs is very unusual, because single-price retail markets have not been the norm for pricing in the bulk of the world over the centuries.

The bazaars of the Middle East, for example, even today treat the stated price as only the starting point for negotiation between buyer and seller. The folks at McDonald’s, by contrast, would frown rather darkly if we were to walk in and bid only $0.79 for a Big Mac.The trader’s markets, even though they are also retail markets in one sense, are never single-price markets. The price of any asset, whether IBM shares, Inco’s 7.75% bonds of 2016, or November soybeans is always stated as current bid/current offer.

The NYSE specialist might quote IBM at 107.05 bid/107.07 offered, just two pennies differential, but the trader who trades “at the market” will pay all or most of this spread. This is the exchange bookmaker’s profit margin. When trading “at the market,” we will pay the offer price in most cases, and the bid/ask spread or a large fraction thereof becomes part of our contest risk.

This form of contest risk varies directly with the liquidity of the market in which we’re trading. IBM shares are exceptionally liquid and trade in large volume most days and the bid/ask spread is tiny, but there is no practical upper limit to how large this spread can be in less liquid markets.There’s one other form of contest risk that occasionally dents our wallets,called slippage.

If we buy or sell an asset at the market or use a stop order to enter or exit a position, some number of times we will experience the thrill of being “skidded.” While our market order is making its way to the trading floor, the market may move suddenly and sharply, and whoops,here comes our order, and WHAM! it’s filled at the now-current market conditions, which are rarely favorable to us.

The difference between our intended entry or exit price and the price we ultimately obtain is the slippage,and we must include this amount in our contest risk.We can readily limit contest risk by negotiating a lower commission rate with the brokerage or by shopping among brokerages for a lower rate.In addition, we can reduce the bid/ask and slippage forms of this risk by trading only in highly liquid markets, or by avoiding the use of market and stop orders except in the most liquid markets.

At first glance, it would seem that we should apply these tactics at every chance, because, unlike the penalty exacted by other types of risk, when we incur contest risk, those dollars are gone forever. Paradoxically though, and unlike with other types of risk, it may not be to our advantage to be ruthless about minimizing contest risk.

If we receive excellent service, good executions of our orders, accurate accounting,and prompt and fair resolution of the occasional account problems from a brokerage, we may quite reasonably decide that these advantages are easily worth a few extra commission dollars per trade. Regarding markets,a decision on our part to participate in only the most liquid markets may (and almost surely will, over time) conjure up other costs in the form of lost opportunity in the less liquid markets.