Managing Your Risk

As traders, we live in a highly uncertain but yet interconnected financial world where events in one market can easily spread to others resulting in a significant increase in unexpected market behaviour. Therefore we need to apply advanced risk management techniques to make consistent profits. Many professional traders believe that risk management strategies are more important than the trading strategies themselves. Risk management has a wide scope of applications which includes all areas of trading such as position sizing, portfolio construction, capital preservations, stop losses, choosing new trades, etc.

In this article we are going to briefly explore methods that can strategically help you reduce your trading risks.

What is Risk?

We start first by defining what we mean by “Risk”. We believe the risk is best defined by:

“the amount and probability of a loss or series of a loss occurring in the life of a trading system”.

The losses included in the above definition are both realised and unrealised. As a matter of fact, unrealised losses (also called drawdowns) play a significant role in the success of traders as they can be stretched and push traders to “margin calls” or cause serious opportunity costs. A margin call is when your broker starts asking you for more deposits or they will automatically close your positions as your losses are getting too big. Opportunity cost is the profits you have forgone in other possible trades, while you are stuck in bad ones. I think we can all admit to this one.

Sources of Risk

Systematic risk is the risk caused by general market conditions and can affect all tradeable securities. For example, during the GFC all market sectors, even those which are traditionally regarded as defensive stocks  (i.e. utilities ) were still impacted by the general negative consensus against securities and experienced significant losses. These sectors are less exposed to business cycles and therefore have the ability to be more stable. However, you will notice the overall unrest during the GFC brought all sectors down.

Chart 1 shows how the S&P 500 (prices on the right-hand side) and the representative exchange-traded funds for consumer staples, healthcare and the utility sector (with their respective prices on the left axis).


Chart 1: GFC Correction

Specific Risk on the other hand relates to the risks existing in your individual trades and is an addition to the Systematic Risk explained above. For example, when you buy BHP, you are exposed to both general market risk and BHP’s individual risk factors such as; earnings growth, iron ore prices, regulation around the mining industry and etc. These risks vary from one security in your portfolio to another. They can cause your particular investment (trade) to either outperform or underperform the market.

There is also another source of risk which is called Event Risk. This risk is associated with events such as wars, disasters, political issues or severe economic news. Current tensions in Ukraine and issues around the US debt ceiling late last year are all examples of event risks.

How to reduce the risks

Diversification, Diversification, Diversification and position sizing are among the most efficient tools to strategically reduce your risks. Diversification is when you start expanding your trading universe from a single product to multi products. For example, instead of only trading EURUSD, you should also include other major currencies, commodities, rates and indices in your basket of a tradeable universe. Remember a robust trading system MUST work across multiple markets. The biggest benefit of diversification is that it helps you mitigate the specific risk so that when your long EURUSD trade goes down (because of say worse than expected employment figures in the Euro area) other non-euro related trades get an opportunity to perform and potentially hedge your risk and help you increase your overall equity.

The important point to keep in mind when diversifying is to choose securities that have low correlations with each other. Correlation is the degree to which two instruments tend to go in the same/ opposite direction.

For example, S&P 500 has a high negative correlation with US long-term bonds. This means that if US markets go up, US long-term government bonds will go down. Using a combination of mathematical and programming tools, we at Trade View have established our own Correlation Matrix. This Matrix can tell us how correlated the securities are by assigning a correlation coefficient to each pair of securities.

A correlation coefficient of +1 means two assets are positively correlated and move completely in the same direction. A correlation coefficient of -1 means two assets are negatively correlated and move in the completely opposite direction.  Using a more detailed version of table 2, each time our trading system makes a new recommendation, we look at the recent correlations and will make new trades based on the correlation and our existing market exposures. For example, if we already have a long position in Euro/Dollar we might take a long position in Copper when the pair have recently shown weak correlations.


Table 1: Correlation of Returns

Choosing the right weight or position size for each trade in your portfolio can significantly contribute towards the smooth and steady growth of your capital. Over-weighting can expose your trade to unwarranted risks in case of failure and can even cause your trading account to enter into margin calls. Under-weighting on the other hand reduces profit potential and makes rewards less appealing when opportunity and transaction costs are taken into account.

Weighting (position sizing) directly relates to risk and is the aspect of trading that is mostly overlooked by many novice traders. Although many position-sizing strategies are beyond the scope of this article (due to their highly mathematical nature) , we have presented a simplified version of one of the popular position-sizing methods.

Suppose you have a trading account of $10,000 and you are willing to risk 2% of your capital per trade.  Also for the purpose of this example, assume you are trading mini FX contracts.  Today your trading system makes a buy recommendation on EURUSD with a stop 100 pips away.

To determine the number of contracts, you will need to follow these steps:

1)      Determine Risk per contract = 100(stop loss)*1(dollar value per pip)=$100

2)      Calculate maximum allowed risk  = 2%*10,000 (equity value at the time of the trade)=$200

3)      No of contracts to buy= maximum allowed risk/risk per contract =200/100=2

Note that to calculate the maximum risk allowed, you should always look at your most recent equity value.

To conclude, we believe that risk management plays a very important part in any trading business but is frequently overlooked. If there is one thing we ask traders to take away from this article is that they have a firm understanding of their own trading system and the potential risk characteristics it may possess before making any further trades.

This is done by actually building your own systems and seeing for yourself whether a system performs rather than accepting what another trader has told you.

At Trade View we have very strict risk management policies in place and encourage traders to do the same. A more detailed approach to our methods and policies is explained in our Systems Building Workshops.

More and more retail traders are building their own automated trading systems and robots to take their strategies to the next level.

Our hands-on Professional Traders will support you in building your strategies into automated trading models.

Register now for our next In-House Systems Building in Melbourne.


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