Page 1, This is book is written as an economic survival guide anyone who might be stressed out about their financial future. The main theme of the book is Risk and Money Management techniques to avoid ruin. The model used in the book is the Modern Portfolio Theory coupled with step-by-step details of the once famous turtle trading (developed by Dennis and Eckhardt) It explains it all. All in detail and special provisions are mentioned to smaller accounts
Risks in Life
I do not fear tomorrow, for I have seen yesterday and I love today
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 risk.
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 control.
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 to make.
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 investment results.
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 profit.
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 entire bankroll.
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 test.
- 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 about them.
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 Return/Risk Ratio
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 applied:
If the index moves up, percent of the time the stock also moves up. Please refer to the ‘Portfolio Diversification’ section of this book.
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 managers.
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 one day.
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 fundamental principles:
- Know how much one is willing to lose before he executes trade.
- See 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).
- Buy the contract only at an acceptable price level.
- If 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.
- Act quickly when you see the risk limits exceeded.
- Close out the entire portfolio if it loses to the overall stop-loss level.
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% level.
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 year capital.
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 control.
- 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.
- Why 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 sizing.
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