Forex Trading Tips: The Risk of Uncertainty

The Risk of Uncertainty

“It has long been argued that investment returns were a reward for taking risks, “ writes Justin Fox in his new book The Myth of A Rational Market Justin Fox which deals with the history of the efficient market theory and the birth of the quantitative finance movement.

“The risk reward relationship made frequent appearance in economics through centuries. While it was apparent that risk and return were related, it was equally apparent that some risks were rewarded more generously than others. Running across a busy freeway is certainly risky but who is going to pay to do it? Frank Night, a leading figure in the Chicago Economics department addressed this question in his 1921 book, Risk, Uncertainly and Profit. He concluded that you couldn’t get paid just for taking on risk, because risk is a measurable quantity that could be insured against. Profit came only when you proceeded in the face of uncertainty.”

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I love this passage from the book because I believe it offers tremendous insight to us as traders. The essence of Night’s argument is that reward actually comes to those who assiduously attempt to eliminate risk rather than embrace it. Taking the simple idea of crossing the road, ask yourself when would be the safest time to cross a busy city highway? (Those of you unlucky or foolish enough to cross the Champs Elysee above ground are exempt from this exercise)

Clearly you want eliminate the risk of darkness, so crossing during the day is more preferable than crossing at night. Also you want to eliminate the risk of heavy traffic, so crossing early in the morning is better than crossing during the middle of the rush hour. Finally, when you do decide to cross you need to be prepared to move quickly and decisively.

Now of course this exercise is utterly idiotic in real life. Who would be dumb enough to wait for the breaking of dawn in order to cross a busy highway? Here in New York, even 80 year old grandmothers coolly jaywalk in front of Mack trucks with alarming regularity. However substitute the words making a trade for the idea of crossing the road and suddenly these precautions are not so absurd.

In fact that is exactly what we do at BK. We spend all of our time trying to eliminate the fundamental risk, the technical risk, the session based risk and the sentiment risk from the trade. And even with all our filters, we are never assured of winning because as Mr. Fox points out, profit only comes “when you proceed in the face of uncertainty. “ Just as you can be run over by a crazy motorist doing 150mph at 5 AM in the morning in our “best case” scenario of crossing the road, so can our trade be sabotaged by myriad of unforeseen developments in the currency market.

However, the key takeaway from Mr. Fox’s insight is that risks can be mitigated and it is our duty as successful traders to minimize their impact by being as selective as possible in both our trade ideas and our execution while at the same time accepting the fact the we always operate in a sea of uncertainty.

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