Risk Management

I hope everyone had a great Easter break!

We went for a weekend trip to ATIC Kuala Lumpur – a trip that has great lessons for trading. The early signs were not propitious.

We arrived at the airport and there was no transport; we arrived at the hotel expecting a non-smoking room with a king size bed and found we had been allocated smoking room with single beds. The events were like black swan events that hit our trading. But ATIC’s Peter and Noraine were there to sort things out – Peter arranged for the transport and Noraine sorted out the room issue. Peter and Noraine formed protective processes to ensure all went smoothly – they were like the processes and preparation in our trading that protect us.

In the next few blogs, I’ll be reviewing the process I call ‘risk management’. Risk Management has two components: money management and trade management. Money Management has two components:

  • a subjective aspect and
  • an objective one.

Money Management looks to answer four questions:

  1. Portfolio Risk: the maximum amount to risk at any one time on all open positions. This is a non-issue if you are trading only one instrument.
  2. Trade Risk: the maximum to risk on any one trade.
  3. Maximum Trade Exposure: the position size for a trade.
  4. Increase/decrease of Size: the process of increasing or decreasing position size.

In my subjective components are two factors. The first is what I call my risk profile. This tells me when I may be likely to breach my discipline. Usually this occurs when I have 6 consecutive losses and/or a greater than 10% loss; or when I have series of wins that accrue a greater return 15% return. I guess that’s what some call fear and euphoria. By knowing when the I am treading close to the line, I can take precautions against a breach of discipline.

The second subjective factor is my loss tolerance. All of us have a ceiling of what we can lose on any one trade and any dramatic rise in capital will impact on this. For example when I went from A$100M to A$250M, I found that I became too defensive and as a result, reduced my Expectancy Return. We can increase this level using the ‘boiling frog’ theory – incrementally increase our risk exposure to allow the desired level.

Objective factors are based on three ideas:

  1. Volatility of the market.
  2. Our Expectancy Return – average dollar win/average dollar loss; win rate/loss rate.
  3. The Ebb and Flow Factor.

In my next post I’ll consider each in detail.

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