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Billion Dollar Trading Losses: Is Biology to Blame?

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JPMorgan. UBS. Societe Generale. These banks have been rocked by gargantuan trading losses in recent years because of excessive risk taking (and trades gone bad) by one or two "rogue" traders.

How can erroneous decisions made by one individual total billions of dollars in damages for his or her firm? John Coates, a former Wall Street trader and author of the book "The Hour Between Dog and Wolf," says biology plays a central role in the infamous trading scandals. A former trader at Deutsche Bank, Coates left Wall Street to study neuroscience and finance at the University of Cambridge. His goal was to find the answer to the question that has perplexed experts for years: why do traders make the decisions they do?

"I am not sure greed is the primary motivation here," Coates says in an interview with The Daily Ticker. "There are institutional incentives to maximize the variance of your trading results. But underlying it all is human behavior."

Coates says traders can succumb to the "winner effect" — a model that has been used by scientists to describe animal behavior. The "winner" becomes more confident and seeks more risk after winning a fight (for animals it's turf; for traders it's stocks) and the biology of that individual (or animal) changes to prepare for more competition.

"This is actually a biologically driven phenomenon," he says. "When we're on a winning streak, in our brain certain chemicals and electrical signals are encouraging us to take more and more risk. Anybody who's spent time on a trading floor and who's taken large financial risks knows that when they are making these decisions their bodies are completely involved in the decision making."

Traders' hearts beat faster, testosterone levels shoot up and traders can actually become physically and psychologically immune to risk by developing a high tolerance for it. Some traders even lose touch with fear, Coates says.

Ultimately this excessive risk taking backfires, leaving financial firms and investors with enormous trading losses. But Coates says there are ways to prevent these catastrophic biological effects on global markets. Risk managers should remove traders on a winning streak by pulling them off the trading floor, even for weeks at a time. Managers can follow the lead of sports scientists by employing "physiological toughening" — physical training regimes that builds one's resilience to the peaks of exuberance and pessimism.

"Every blowup I've seen on Wall Street or in London with losses north of a billion dollars have occurred at the hands of a trader who is at the end of a multi-year winning streak," he adds. "Traders on a winning streak — those you should be worried about."

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