Risk Me Once and Risk Me Twice and Risk Me Once Again

When we enter a trade, we become subject to yet another type of risk unknown to the gambler and the bookmaker, although our banking friends see a form of it from time to time. Being sensible people, we attempt to limit the dollar or percentage loss that an adverse market movement might cause us. To this end we set a loss limit either by placing a stop-loss order with our brokerage or by carefully watching our new trade and preparing to exit at a (presumably predetermined) point if the trade moves against us.

The risk that may accompany these pragmatic tactics, called wiggle risk, occurs when we are consistently too conservative in setting our loss limit.You and I both know from long experience that some markets’ prices fluctuate more over time than other markets’ prices do. If we would try to set our loss limits, therefore, at the same dollar or percentage level for every market in which we trade, it’s unfortunate but unavoidable that in some considerable percentage of trades our fixed loss limit will end up being either too generous or too cautious.

Now, no one in his right mind would advocate accepting, except infrequently and in very specific instances, “too much” risk in any trade, but demanding “too little” risk is often a worse poison.If we systemically insist on too little risk, we will be taken out of our trades with a loss far too frequently, simply due to the ordinary price fluctuations of the market. We must expend some effort, then, to devise a means through which we can set acceptable and realistic risk levels market by market.

I suppose it might be interesting to be on such a poster, but, on the whole, I’d rather be in Philadelphia.Our unfriendly acquaintance, counterparty risk, is definitely present in the world of trading. Actually, this risk causes more headaches for the incautious trader than it does for the other parties who attempt to make money with money. First off, we have more total parties involved in our enterprise than have the banker, the bookie, and the gambler, and the very presence of these extra parties increases the likelihood of encountering one form of counterparty risk.

We usually place our order with a trading desk, or with a broker who relays it to a trading desk, which in turn passes it along to a trader on the exchange floor. When our order is executed, both we and whoever has taken the opposite side of our trade must be informed, the two orders matched up and cleared, and the books of the brokerage(s) adjusted to reflect both our and the other trader’s new position(s).

Simple mechanical errors in clearing our trade are rather common, but are easily fixed up after the fact with no threat to our capital. We call our broker and point out that we bought 800 shares of General Electric, not 300 as the confirmation slip says, or that we sold 10 December crude oil at 21.92, not 21.82. In the great majority of cases, our broker agrees straightaway with our viewpoint, sets to work putting matters to rights, and that’s the end of it.

We should, of course, facilitate this process, because both we and the broker will make inadvertent verbal or typographical errors once in a while. We’ll just insist that the broker repeat our order before sending it off
to the exchange floor, and we should without doubt maintain a written record of the orders we place. These practices will avoid all or almost all instances of misunderstanding, or what might be called accidental counterparty risk.

Like the banker and the insurance bookmaker, we may sometimes encounter plain fraud. There’s no avoiding the fact that there are dishonest brokers and brokerages, notwithstanding the efforts of the SEC, NASD, CFTC,and NFA, and we deal with these persons at our peril. However, by exercising a little care and applying a bit of economic common sense, we should be able to elude the clutches of these slimy bottom-feeders.

We have a couple of straightforward ways to do so.The better and easier way to avoid a less than scrupulously honest broker is to know your broker personally and over a long period of time during which he has been a broker. Too obvious, you say? Perhaps, but some traders do not seem to agree. I’ll tell you right now that I had known my present futures broker personally for 17 years before opening a trading account with him.

Previously, I’d known my former futures broker for 19 years before dealing with him. To date, I can’t recall any sort of trading dispute or account problem that wasn’t resolved more or less immediately, within the week at worst. Just as for the banker, our having personal knowledge of the people with whom we deal lowers our risk.