Trading and Risk Aversion

BarroMetrics Views: Trading and Risk Aversion

It is now well-known that humans are risk averse when making decisions perceived as’keeping what is theirs’; and they are risk-taking for an outcome still to be attained.

In a recent study,  Valerie Reyna, professor of human development in Cornell’s College of Human Ecology found that her sample of US intelligence agents “are more prone to irrational inconsistencies in decision making than college students and postcollege adults, are more prone to irrational inconsistencies in decision making than college students and postcollege adults” (see Cornell Chronicle Nov 14).

If ‘trained  agents’ are unable to adjust for this human foible, what can a retail trader do to avoid it?

I have found that it’s not that hard…..but you do have to apply the process.

Here is the process: each time you have a decision to make, you frame the question in both formats – risk accepting and risk adverse.

For example: going into this morning, I was short the AUDUSD. Based on the price action, I decided I wanted to exit the shorts at an average entry price of .9575

I believed that there was:

  • a 40% probability that the AUDUSD would go to above .9409
  • a 90% probability that it would go to .9343 and
  • a 40% probability that it would go to .9290

I was faced with this decision when the AUDUSD was trading at .9475.

Here’s the process in action. I asked (in writing):

  1.  First thing I did was work out the resulting probabilities. For example, let’s compare exiting at 0.9409 rather than 0.9343: in pip results, we’d 165 as against 231.5 i.e. a difference (loss) of 66 pips. But that’s not the end of it, since there is only a 40% chance of getting to .9409 and a 90% of getting to 0.9343, I’d need to take that in consideration. Taking the probability into consideration, by waiting for .9343, I’d be better off by 135 pips. 
  2. I then wrote out the choices as follows: 

  • ‘How would I feel if I held out for .9343 and the Aussie went to .9409 (knowing the facts in [1])?
  • ‘How would I feel if I exited at .9375 and the Auusie went to .9343 (knowing the facts in [1])? 
  • ‘How would I feel if I did not exit at .9375 the Aussie went to .9409 (knowing the facts in [1])?

3.  I did this for each scenario. Probability speaking, the ‘best’ result was to wait for the move .9290. But the difference as a percentage of capital was 0.05%. The process showed that the regret factor             (of being exiting at .9409) would have more than outweighed the potential gain by not exiting at .9343. So, I exited the position at that price.

Admittedly, a large part of the final decision was influenced my view was that if the Aussie did get to .9290, we’d see sideways market develop between a Primary Sell Zone (.9379 to .9385; Max Extension at .9408) and Primary Buy Zone (.9295 to .9283; Max Extension at .9269). That would give me a chance to resell should the market get to .9290. That said, I also did consider how I would feel if the Aussie broke down without forming a sideways market (& I had exited at .9343).

Can Aussie breakdown without  my reinstating my shorts? Of course it can. But, I am comfortable knowing I have made the best choice for me in the circumstances.

In Figure 1 we have the 60-minute AUDUSD chart that formed by the decision-making process.

audusd-60-min.png

FIGURE 1 AUDUSD 60-minute

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