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Risk, Trading & Human Psychology

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Have you seen the Seinfeld episode where George Costanza discovers the power of doing everything the opposite of his natural instincts?  "Why did it all turn out like this for me?  I had so much promise.  I was personable.  I was bright.  Oh, maybe not academically speaking, but I was perceptive.  I always know when someone's uncomfortable at a party.  It all became very clear to me sitting out there today, that every decision I've ever made in my entire life has been wrong.  My life is the complete opposite of everything I want it to be.  Every instinct I have in every aspect of life, be it something to wear, something to eat... it's often wrong."

Anyone who has ever traded commodities is familiar with the mind games that start the instant a position is put on, and how human nature can often work against good trading decisions.  I worked with a commodities broker that would often exclaim “let the games begin” whenever his clients initiated a new trade.  

In his book “Your Money & Your Brain” (worth a read), Jason Zweig explores some of the neurological behaviors associated with trading and making/losing money that I think apply equally to commodity trading and hedging.  He says the neural activity of someone who is making money trading is indistinguishable from that of someone who is high on cocaine or morphine.  On the other hand, financial losses are processed in the same areas of the brain that respond to mortal danger.  Zweig provides some compelling explanations as to why human instincts can work against good, rational trading decisions.  Powerful stuff. 

This all underscores the importance of having your objectives clearly spelled out and supported throughout the organization - to the highest level of management and the board.  Because when we know why we are undertaking a particular hedging strategy and have a clearly defined strategy, the human psychology and emotion is taken out of it and the odds of success go way up.

Establishing objectives and strategy relating to commodity risk is easier for some types of businesses than others.  Most merchandizers and processors in the middle of the value chain tend to focus on their core business and hedge the majority of their commodity-related risk.  There are discrete moments when they buy and sell cash commodities, against which offsetting hedges can be placed. 

For natural longs and shorts on the far ends of the value chain, hedging strategies are more difficult to define, as their natural long or short accumulates continuously and there is no discrete moment they get long or short.  An airline is perpetually short jet fuel - so when, how, and how far out should it hedge its exposure to fuel prices?  An energy producer is perpetually long crude oil or natural gas - so when, how and how far out should it hedge its price risk? 

The answer involves a number of important considerations - the corporate strategy being pursued, how shareholders perceive the company, the suitability of available hedging instruments, the magnitude of the commodity risks in relation to the company’s capital, the nature of its customer pricing arrangements and the competitive dynamics of the marketplace. 

For example, a dividend-paying energy producer may view the protection of its dividend as a key strategic objective.  Another producer may be viewed by its shareholders as a play on a particular commodity or sector and thus will be reluctant to engage in hedging strategies that cap their participation in commodity price increases.

Whether you are a hedger or a speculator, being clear about your objectives (throughout the organization), goes a long way toward taking the emotion and psychological aspects out of commodity trading. 

As the field of neuroeconomics develops, we are also gaining powerful insights into the psychological and biological factors that drive investing and trading behaviour – and ultimately how to translate these factors into superior trading and risk management decisions.

Ron R. Gibson

 

Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca


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