The Risk of Trading: Mastering the Most Important Element in Financial Speculation

POSSIBLE LOSS VS. PROBABLE LOSS

Advice and experience come in many forms. The beauty about continuous lessons-learned opportunities in business is that most of them come from an experience that at one point turned sour. The value offering provided in this text is to limit those real-life business experiences with particular focus on the high-severity exposures. One of the more misunderstood and overabused concepts in trading is that of maximum possible loss vs. maximum probable loss.

The terms have roots in the insurance industry and other genres in the risk transfer business. Used to estimate physical loss due to a peril, possible maximum loss is the ultimate loss that the insurance company would ever be exposed to. Worst-case scenario quantification was the unchallenged norm for the insurance industry well into the 1960s. Thanks in part to more advanced and realistic analytical thinking and the computerized tools that came along with it, the business of insurance migrated toward what losses most likely would occur rather than assumptions of total loss.

In our business of trading, that transition of examining the more realistic exposure at times is still stuck in the Woodstock era. Even the more aggressive trading professional still thinks of a “what's the worst that can happen” theory that has been the litmus test for their decision-making process. In our insurance industry example, actuarial professionals usually consider the maximum exposure on an insured asset, such as a piece ...