I do not fear tomorrow, for I have seen yesterday and I love
William Allen White
What is Risk? Risk is the chance of not having enough money when
you need it, to buy something important. Risk is going against
the current, taking the hard way against high odds is taking
In a world of constant change, taking risks is considered to be
accepting the flow of change and aligning ourselves with it. It
does seem to be a reckless endangerment, but for those who
understand reality, risk is considered to be actually the safest
way to cope with the changing uncertain world.
To take a risk is indeed to plunge into circumstances we cannot
absolutely control. But the fact is that the only circumstances
in this life that we can absolutely control are so relatively few
and so utterly trivial as hardly to be worth the effort. Besides,
the absence of absolute control, which is impossible in any case,
does not entail the absence of any control, or even significant
To be more specific, the sort of risks that put one in a position
to control one's lot in a world of incessant change are the risks
that attempt to add something of value to that world. To create
value, to focus one's efforts on increasing the fund of that
which is worthwhile, involves a sort of risk. And yet,
paradoxically, it provides with the greatest control over a
changing world and maximizes the chances to achieve a truly
meaningful personal satisfaction.
The main difference between an amateur and a professional trader
is that the latter always tries to understand and control
portfolio risks. Before entering into any trade, good traders
first think about how much risk to take and how much risk
exposure comes with a particular trade selection. Only then do
they allow themselves to think about how much profit they stand
Prudent investors always cut down their position and exposure if
they determine that a portfolio carries too much risk. They
calculate this all-important estimation by employing Risk
Management, that set of methods and procedures taken to estimate,
quantify, and control risk for the purpose of achieving optimal
Risk management is the difference between success and failure in
trading. Trading correctly is 90% money and portfolio management,
a fact that most people want to avoid or don't understand.
Capitalism rewards those with the brains, guts and determination
to find opportunity where others have overlooked; to press on and
succeed where others have fallen short and failed. The right
decisions lead to wealth and success; the wrong ones lead to
bankruptcy and a redistribution of resources from weak hands to
strong as capitalism rolls on.
It has been said that the amount of risk we take in life is in
direct proportion to how much we want to achieve. If one wants to
live boldly, then he must make bold moves. If the goals are
meager and few, they can be reached easily and with less risk of
failure, but with greater risk of dissatisfaction once achieved.
Some people are kiodiophobic (risk averse) while others are
kiodiotropic (risk seeking). The phobes are hesitant to pull the
trigger, keep their bets small and have uneventful performance.
The tropes pull on any excuse, bet large and take thrilling
roller coaster rides.
There are two kinds of risk, blind risk and calculated risk.
Blind risk is the calling card of laziness, the irrational hope,
the cold twist of fate. It is the pointless gamble, the emotional
decision. The man who embraces blind risk demonstrates all the
wisdom and intelligence of a drunk trying to speed through heavy
traffic. Calculated risk has proven to built fortunes, nations
and empires. Calculated risk and bold vision go hand in hand.
Using mind, watching the possibilities, working things out
logically, and then moving forward in strength and confidence,
managing risk and dealing with it responsibly is what required in
a successful trader.
The trick is to come to terms with one's own tendencies and find
a system that honors their psychological needs and also shows
For gamblers from blackjack to horse racing as well as all
traders, making serious money demands they get serious. As a
result, they take a completely different approach towards betting
from people who enter these endeavors for the action, the
excitement and, of course, the dream of winning big.
Nearly every profitable investor keeps continuous and detailed
records of their trading decisions, thoughts and observations.
Recording in written form forces them to function in a
disciplined manner. Details on paper structure the decision
making process. Anxiety, greed and fear are replaced with
confidence and determination. A constant review of the
decision-making process that goes into each trade is not
enjoyable. But, the process of self-examination is crucial to
successful trading. Keeping a journal of decision-making that
records when, where, why and how much to bet on each trade or
wager is a good control strategy. The idea is to reach a comfort
zone, stay within that zone and to quit whenever tempted to leave
it. Keeping records is a part of managing money, and if one is
not disciplined in money management, he is going to lose his
So controlling risk is crucial because losses determine that
something is wrong. If a person doesn't know how to determine
when he is wrong, then he is headed for disaster.
Developing and maintaining a record-keeping system:
Develop and maintain a record-keeping system that works for you.
Critique the performance in writing each day.
Write down the personality characteristics or take a personality
Write those parts of the personality that make you a successful
trader, and those parts you must constantly guard against.
Write down the trading rules and educate one as much as possible
More risk controlling tips: to become even-tempered about money
takes practice, one must detach emotions and ego from what he is
doing. Being calm, cool and collected and not getting excited
about profits will help you in preventing losses. If one cannot
control greed, fear and hope then trading might not be for him.
Performance Benchmark, Beta,
Correlation, Volatility and
If an investor bought a stock at $100 and sold it six months
later at $116, then he would realize a profit of $16. His
annualized return would be 32%. No doubt, this is a good
investment result. Is this a better or worse investment compared
with others? Without systematic analysis, we cannot tell: to
properly evaluate investment performance, we need to consider the
return, the risks involved, and how the outcome compares with
other possible investments. In order to quantify risks and
measure risk-adjusted performance, following concepts are
If the index moves up, percent of the time the stock also moves
up. Please refer to the 'Portfolio Diversification' section of
This serves as the measure of a portfolio's risk relative to the
market; if the index moves 1 percent, then the stock moves Beta
percent. In Position Trading, the beta of one currency rate is
often computed with respect to another currency rate.
For trading applications, daily volatility is a very useful
measure of risk: percent of the time, stock price moves up or
down percent in a day. It is important to know the difference
between this daily volatility and the annualized volatility,
which is used in stock option and derivatives valuation.
The Return/Risk Ratio is defined as R/v, the higher the ratio the
better the performance. If we plot the return against risk for
many different kinds of investments, we get a chart like that
presented in Figure below:
Zero-Risk Investment might be likened to a bank account that
earns risk-free interest. At the other extreme, some individual
stocks are extremely risky, leading to a great variation in the
range of potential return or loss. In examining many different
kinds of investments over long-term periods (say ten years), a
graphic representation would appear like a cloud with a rather
clear upper boundary - the so-called "Efficient Market Frontier."
If an investment lies on the efficient frontier, it is considered
"optimal" or "advantageous.
Investing/Speculating is a "zero-sum" game. On average, passively
buying currency contracts and holding them does not generate
returns. A successful trader makes positive returns by trading
skillfully and consistently.
The Sharp Ratio is a measure of a portfolio's excess return
relative to the total variability of the portfolio. It is named
after William Sharp, Nobel Laureate, and inventor of the capital
asset pricing model. Let the annualized return of the portfolio
be R, the risk free interest rate r, and the annualized
volatility v, then the Sharp Ratio is (R-r)/v. It is equally
applicable to equity, fixed-income, commodity traders and fund
VAR (Value At Risk)
Most leading investment and trading houses use VAR as one of
their main risk measures in routine risk-management operations.
VAR is an absolute risk measure for the portfolio, in units of
dollars per day. In a single trading day, there is a 95%
probability that the portfolio will not lose more than VAR. For
example, if the VAR value is $800, then one can assume that it is
95% certain that the portfolio will not lose more than $800 in
Hedging means the specific actions one takes to reduce or
"neutralize" risks. Hedging entails three steps: First, analyze
the portfolio to identify and quantify risks and their sources.
Second, in accord with a risk-management system, add, remove, and
adjust holdings so that the risks are reduced or neutralized.
Third, execute the trades necessary to implement the new
portfolio. Sometimes hedging is as simple as selling part of the
riskiest instruments in the portfolio, or adding a less-volatile
one to it.
Single Trade Risk Management
Single-trade risk management can be summarized by these
Know how much one is willing to lose before he executes trade.
if the instrument is sufficiently liquid (active) so that one may
buy or sell promptly.
Determine the cut-loss level before trading.
Determine the profit target (take-profit-level).
the contract only at an acceptable price level.
the trade starts to win significantly, raise the stop level so
that the Winner Will Never Become a Loser.
Take profit promptly as the trade reaches the profit target.
The risk management process has to start before one begins a
trade. Most important, one must know beforehand how much one is
willing to lose, along with how much one can lose in a planned
trade. For example, before doing a trade, one should first
consider potential losses, and decide if the stop-loss level is
reasonable and acceptable.
Portfolio Risk Management
If one actively manages the risk of each trade in the portfolio,
the whole-portfolio risk will be well under control. After all, a
portfolio is just the aggregate of all individual single trades.
However, it is also important to manage the overall risk at the
portfolio level. The following is a list of key points for
managing portfolio risk:
Know the overall risk tolerance before building up the portfolio.
Determine the overall cut-loss level.
Diversify the investment in different stocks.
Actively manage the risk of every individual trade.
Know the overall risk and where the risk comes from.
quickly when you see the risk limits exceeded.
Close out the entire portfolio if it loses to the overall
This last point, "Stay in the game," is most important in trading
and investing. It refers to cutting losses before they are too
big. One can remain active by always recognizing risk limits in a
trade, cutting losses and building profits.
Recent studies have shown that people don't tend to be rational
economic actors; their decisions are based in part on their
reactions to the facts at hand.
If one could always pick tops and bottoms, money management would
not be needed. That is not possible though. Pretend a trading
system was 99% accurate. The 1% failure rate could still wipe a
trader out if he uses no money management. The 1% failure rate
could be a loss that far exceeds the winners that you accumulate
with the 99% accuracy ratio.
The risk-management strategies provide the crucial means of
surviving and growing in today's market by applying the same
rational controls that keep long-experienced traders ahead.
A fund experienced substantial trading losses in the first seven
trading days that consumed nearly all of the fund's capital.
These losses occurred principally in three position groups. The
fund's portfolio was under liquidation and there was a strong
possibility that there may not be any equity left at the end of
the liquidation. The fund came into the year 2003 aggressively
positioned in three trade groups. 1
The fund held a significant position; it had a long position in a
parent company and a short position in a 63%-owned subsidiary of
the parent. The two stocks had exhibited a very high degree of
correlation and low level of volatility. The underlying merits of
the position were considered extremely attractive from both a
valuation standpoint and a timing standpoint. In fact, the
after-tax 63% position in the subsidiary was approximately equal
to the market value of the entire parent company so that by
owning this position, one owned the parent company's valuable
core business at minimal cost.
The fund's second position was a relative value position in the
national bank sector, which consisted of long positions in three
banks, a short position in one bank and some short index futures
as a hedge. The position was established recentlyas some of the
weaker national banks were heavily sold off in a market panic
late in the year.
Third, the fund held a significant position in a national tech
stock that had also been excessively sold off in the last quarter
of the year. A large degree of panic selling was detected along
with aggressive and large short sales of the stock.
The start it had was definitely not a good start at all. In the
first two trading days the fund lost approximately 15% of its
capital. This was very concerning as it immediately put the
traders in a precarious margin position and forced them to
consider unwinding positions to raise margin. The other
concerning issue was that much of the adverse activity in their
positions took place in the last half hour of trading each day.
While trying to raise cash in some of the fund's positions, the
fund again sustained a loss of an additional 15% of its capital.
Unfortunately, the next day fund lost another 16% of it's
capital. Once again, for the fourth day running, much of this
loss occurred in the final hour of trading. After the close of
the fourth day, prime brokers decided to exercise their right to
supervise further trading/liquidation in the positions as per the
standard prime brokerage agreement.
Attempts were then made to raise liquidity by selling positions.
Traders did manage to work out of some size across the various
positions, but the liquidation had the effect of further losses
in the fund's positions. The fund ended the day down a further
12% and the week with a loss of approximately 58% of its capital.
Eventually, in accordance with the prime brokerage agreement it
was decided that they needed to liquidate the fund's two largest
positions, the stub trade and the long tech position, as soon as
possible. Various block trades cleared most of the exposure to
the two positions but left the fund with a loss for the day of
approximately 40%. Equity in the fund was now hovering at the 3%
Traders continued to sell out the relative value bank trade and
clean up some smaller less liquid positions. They were left with
very little equity in the fund, somewhere around 2% of start of
The fund still has positions that total approximately $80 million
long and $117 million short. Of the long positions, approximately
$15 million is held in lower liquidity stocks that may take some
time to properly liquidate. They are still working hard with the
prime broker to trade out of the remaining positions in as clean
a fashion as possible.
Now let us identify the facts/errors made by the fund manager and
take an account of things a trader should look at before
venturing his capital:
Having losses in 7 days that consume all capital is no risk
Diversification limited to 3 markets is a ticking time bomb.
Having 2 out of 3 positions highly correlated is no risk control.
Value based trading & technical trading does not mix.
buy into markets going straight down?
Money Management is also sometimes called asset allocation,
position sizing, portfolio heat, portfolio allocation, cash flow
management, trade management, capital management, position
management, size management, bet size selection, lot size
selection, or even Risk Control, Equity Control, and Damage
Control. Money and risk management, plus diversification, are
interwoven with trend trading. There are rather long periods in
which no ascertainable trends can be seen in a given market. This
period eventually passes and some trend manages to re-establish
itself. Trend trading mandates that we wait for these periods to
pass and not trade until a strong trend is observed.
'Money Management' deals with how to optimize capital usage and
to view a portfolio as a whole. There are 2 steps to implement
proper Money Management:
The determination of what (fixed or non-fixed) fraction of a
portfolio's total (or again fixed or non-fixed fraction) equity
to risk on each trade expressed in denominated currency values.
Our money is at constant risk as
well. No place is risk-free. The good news is that efficient Risk
Management can turn risk into profit. It is about managing losses
and open profits (unrealized trading returns) also the "process"
of saving. The calculation of how many contracts should be held
in a position, once a trade entry is signaled or the number of
contracts/stocks that should not be traded in fractions and must
be cut down to a whole integer is referred to as position