To me, VAR is charlatanism because it tries to estimate something that is not scientifically possible to estimate, namely the risks or rare events. It gives people misleading precision that could lead to the build up of positions by hedgers. It lulls people to sleep. All that because there are financial stakes involved.

To know the VAR you need the probabilities of events. To get the probabilities right you need to forecast volatility and correlations. I spent close to a decade and a half trying to guess volatility, the volatility of volatility , and correlations, and I sometimes shiver at the mere remembrance of my past miscalculations. Wounds from correlation matrices are still sore.

NT: That's completely wrong. It's not better than what you had because you are relying on something with false confidence and running larger positions than you would have otherwise. You're worse off relying on misleading information than on not having any information at all. If you give a pilot an altimeter that is sometimes defective he will crash the plane. Give him nothing and he will look out the window. Technology is only safe if it is flawless.

A lot of people reduce their anxiety when they see numbers. They want a triple digit delta or gamma for example, not taking into account that it is foolish to be precise with deltas when you don't even know the parameters.

Before VAR, we looked at positions and understood them using what I call a non parametric method. After VAR, all we see is numbers, numbers that depend on strong assumptions. I'd much rather see the details of the position itself rather than some numbers that are supposed to reflect its risks.

Clearing firms understood that very well. Ironically, the stock market crash coincided with the discovery of this so-called parametric system used to run the risks of option traders. In the old days, the clearing firms looked at how many calls you were short and how many you were long and if you sold a lot of calls they would get nervous and call you up and ask you to liquidate some of them. After they went to parametric monitoring of option positions using second rate statistical methods, the options traders started building up massive short put positions that, along with portfolio insurance, helped to accelerate the crash. Now they're coming back to square one with their non parametric methods, particularly with the puts.

NT:Most institutional traders don't pay for their losses. If you make a dollar, you get paid ten cents. If you lose one dollar you pay zero. That obviously looks like an option payoff.

So let's say your trader trades two bonds of slightly different maturities. They're very close but because they have illusory close maturities the position will not produce a big VAR number. Sometimes they are treated as the same bond. The position, however, could easily bankrupt the company because of the sheer size that was built on it. An institution just last month lost bundles because a trader built up massive positions in Bunds against German swaps as their system, otherwise sophisticated, did not differentiate between them.

NT: VAR players are all dynamic hedgers and need to revise their portfolios at different levels. As such they can make very uncorrelated markets become very correlated. Those who refuse to learn from the portfolio insurance debacle do not belong to risk management.

In 1993 Hedge funds were long seemingly independent markets. The first margin call in the bonds lead them to liquidate their positions in the Italian, French and German bond markets. Markets therefore became correlated. Markets that were correlated became independent.

VAR is a school for sitting ducks. Find me a dynamic hedger who is a reluctant liquidator and I will front run him to near bankruptcy.

NT: Bingo. Even more: Our perception of what's going on in the real world can hurt us simply because we have to realize that we are the major players ourselves and we act according to our perceptions. In physics it's called the Heisenberg uncertainty principle. In the social sciences its even more pronounced.

When people ask me what alternative to VAR I have to offer, my answer is: smaller leverage, less naive diversification, less reliance on dynamic hedging.

NT: As a trader, my job is to understand biases and trade on them. There are all kinds of biases. The most common is the small sample bias. Let's say you have 1 to 1000 odds you will come home every day with a dollar and once in a while you lose $1000. Many traders show very steady incomes but they could be fooling themselves because they don't have a long enough period of time to chart their performance. Their Sharpe ratio will not be indicative. In option trading, there is a similar bias. Short premium option traders, typically those who sell out-of-the-money options, are more likely to make money on a daily basis and then blow up. Likewise the yield hogs, those traders who would take any risk for a few basis points. You can fool yourself with your Sharpe ratios, and you can fool all of the financial engineers, but you can't fool an old Chicago trader who went bankrupt twice.

Another bias is what I call the size bias. If you have twenty thousand traders in the market, sure enough you'll have someone who's been up every day for the past few years and will show you a beautiful P&L. If you put enough monkeys on typewriters, one of the monkeys will write the Iliad in ancient Greek. But would you bet any money that he's going to write the Odyssey next? You know that because of the sheer size of the sample, you're likely to find a lucky monkey once in a while. But the same applies to traders.

A third bias is the survival bias. Everybody will tell you that stock investing is a great idea because it's been back-tested by some serious Guru and if you bought one share of some stock during the revolution you would have owned the GNP of some banana republic. But you forget that your back testing is only on stocks that are alive today and did not cover stocks in imperial Russia that a rational investor would have bought at the beginning of the century. Many continental stocks were recycled into wallpaper. When you look at markets you are only looking at the remnants, the parts that have survived. Or take real estate. People always say it goes up. But that works only if you always bought in places that became fancy.

DT: Sure, take upside calls on the S&P. Retail investors tend to sell a lot of higher strike calls in equity markets and buy a lot of lower strike puts. You look at the distributions and you assume you're being compensated with the volatility differential buying higher strike calls and selling lower strike puts. But once you start running it, you will notice that some undetectable behavior makes you lose money on the trade. And your back-testing cannot fully detect that.

It's more intricate than it seems. It's not just the volatility of the upside or the downside, its the volatility around a particular strike that has a large open interest. We call these sticky strikes. The markets tend to compress in variation around these strikes. Good traders can sense that.

Also when you a stock warrant on an illiquid stock , you need to take into account that your own hedging will reduce the volatility and stabilize the stock. That added to that of other dynamic hedgers.