Hormones, incentive, experience "make best traders"

LONDON (Reuters) - British scientists say a perfect combination of testosterone, experience and a hunger for a share of profits can produce financial traders who consistently outperform the market -- even during a crisis.

Traders work on the floor of the New York Stock Exchange November 9, 2009. REUTERS/Brendan McDermid

Researchers from Cambridge University who studied 53 traders from the City of London financial district found that several years of trading experience, the right kind of hormones and profit-sharing incentives make profitable, prudent risk-takers.

The study looked at male “high-frequency” traders, who buy and sell financial products but only hold positions for only a few seconds, and the “Sharpe ratio” performance measure -- a ratio between trading profit and the level of risk taken.

The Sharpe ratio was developed in 1966 by former Nobel prize winner William Sharpe to measure risk-adjusted performance.

“A trader making $100 million would normally be considered a star, but not if the trader could just as easily have lost $500 million. A trader’s Sharpe ratio is a better measure of skill than profits alone because it would expose this trader as reckless,” said John Coates, a Cambridge research fellow in neuroscience who previously worked on Wall Street.

The researchers compared traders’ Sharpe ratios with the Sharpe ratio of the DAX German stock market index and found that more experienced traders scored significantly higher -- an average of 1.02 compared with the Dax’s average 0.53.

The traders’ Sharpe ratios also increased markedly with the number of years they had been trading -- a result suggesting that learning plays a role in increasing returns, they wrote in the study published in the Public Library of Science journal.

Coates said his study suggested banks should use improving Sharpe ratios over time as an indication that a trader “has developed a skill worth paying for.”

“The traders in our study ... received no bonus, only profit shares. They had therefore a strong incentive to lower, not raise, the variance of their profits,” he wrote in a commentary.

Previous studies have suggested that the hormone testosterone plays an important part in the work of financial traders, with evidence that male traders will make much more aggressive trades on days when their testosterone is high.

Coates said this risk-taking trait was important, but only counted if it was combined with training and the right incentives: “In trading, as in sports, biology needs the guiding hand of experience,” he wrote.

Editing by David Cowell