Practical Risk Management 2

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Updated: 06 October 2020

Risk and p/l management is great, but how do we apply it practically? You can read hundreds of books on risk management, but very few will offer you a plain simple and objective method to use.

By now you should have read the articles on market psychology, risk management, practical risk management 1. Next is the practical part 2, where I will go through a live risk management process with one of the traders I worked with for several years. This is the same trader I mentioned in the first part of the practical risk management article. Let’s give him a name, Peter.

Peter came to me years ago. He had traded for over 15 years, and was producing good results. He is one of the more stable traders I have ever met with an extreme discipline, and I have met many traders over the years, including all the guys I managed while working as head of trading at investment banks.

Peter is a private trader and has done well for himself over the years. He has a very disciplined approach and sticks to his strategies. When you see his p/l below you will probably think “this guy does not need help”, but all traders need help, just as all football players need a coach, a physiotherapist etc, a truly great trader needs help in terms of risk management, psychological aspects etc. Peter came to me complaining about his trading as it was “grinding” almost too perfectly. This type of trader has the natural stop loss mentality, they will not allocate too much risk into one asset and will always survive making at least “some” returns.

Peter’s main problem was utilising more risk and adding leverage to his risk in times of good performance. Every time he was closing in on previous highs in p/l he would get “scared” of his own success, ending in very long consolidations in p/l at highs, often ending with a move lower in p/l in the short term. I would say his main problem is that an increase in risk, he would do the same thing but in bigger size, would make him nervous and ended up affecting his psychology in a negative way.

My light work with traders and portfolio managers would be around the p/l management as well as some psychological aspects. The full in depth “coaching” is made up of in depth understanding of the background of each trader from a psychological point of view, basically “dismantling” the trader and then working from zero.

With Peter I worked once a week. The first step of the method is to have the trader write a diary of his trading.

It would be very brief:

What did you do good, what did you do bad, what assets did you trade, did you follow the plan, if yes/no why, how did you feel prior to the trading day, did you sleep well, did you drink anything, did you work out, did you argue with your partner.

These are all important factors to write down on a daily basis, and finally you write down your daily p/l and add it to the excel chart.

Below are two random years from working with Peter. First time he came to me his p/l was around day 50 in the chart below. Previous years were all grinding higher, but without much volatility, either way.

I explained to Peter, we need to add moving averages according to the methodology, after first having “dismantled” his psychology. We started off with the 8 (red) and 21 (green) day moving averages that tracked the aggregate p/l, blue line.

Note the rather sharp increase in risk I motivated Peter to do rather straight away. We got the desired p/l hike rather immediately, taking the level to a new plateau. Just as all good projects, you usually hit a bump immediately, our bump was a huge profit warning in a single name Peter unfortunately was long around day 85. Note the immediate cut down on risk after this hard day down in p/l.

Also, observe that due to the previous hike higher in p/l, and the aggressive “take down” risk, there was actually no huge damage done. The method told us to stay in the game, trade small, and just when we climbed above the short-term moving average, we worked jointly into pushing more risk. The profit warning was just a one off, and due to the method telling us to deploy more risk I pushed actively Peter to take on more risk, despite at the time him feeling a bit down post the profit warning.

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Thinking about the past makes little sense, so all focus must be looking forward. Many traders usually get scared to push, especially after such a blow after a profit warning, but note how Peter is pushed into taking more and more risk as we took out new highs in p/l and were well above the moving averages.

Around day 97 the p/l is back to new highs but we entered a small consolidation, where we crossed the 8-day average which led to quick de risking, but nothing huge. Note Peter never saw his p/l fall below the 21-day average, and just as we once again climbed above the red line, I had to push Peter into taking more and more risk as whatever he was doing was working great. I remember Peter feeling uncomfortable and wanting to take chips off the table, but I had to push him into trading even more size. The end result was much higher p/l, that got a proper boost with me pushing the risk to very big levels for Peter when his p/l started going parabolic around day 145.

The parabolic peak came very suddenly with another mini warning in a long stock Peter had, but with his confidence and the methodology working so well, we let the risk get reduced automatically.

Notice how the p/l ends with a slow grinding higher into the end as peter was never “allowed” to take time off and had to stay in the game. He briefly touched the 21 day average, but never went much below it.

Below chart shows the next period.

I am showing this chart for once reason. Usually people get scared when they make good returns and then later revisit those highs. The instinct is to reduce trading, take time off etc but these are all fallacies. Note how Peter pushed the highs (a previous problem) with deploying more risk. This used to be a huge problem for him before, but the methodology was there to help him.

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This period ends once again with a drop in p/l, this time not a profit warning, but note how confident Peter is in his trading. The p/l is automatically traken care off with reduction in risk and Peter can end this 200 day period well.

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Below is the next year in Peter’s trading.

The year starts off fine, but in early March the p/l starts flattening out. Whatever he was doing has stopped working, but there is no damage to the p/l. In times like these it is vital to stay in the game, trade, but not push anything. One thing is important, to not stop trading. Boring p/l is just a consolidation but must never be stressed. In a consolidation, the important thing is to not start overtrading and keeping risk low, but should the p/l break down, be on the alert to reduce risk, but also be equally alert on increasing risk immediately should p/l start moving higher.

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Peter is doing exactly what he should in this situation. Keeping risk well managed, but since his p/l “buffer” from the start of the year is good, he is keen and quick on deploying more risk as soon as the p/l starts moving higher. This is how you build a higher level in p/l. Full of confidence and with a good p/l buffer, trading well above the moving averages.

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As p/l moves higher Peter is pushed into taking on even more risk resulting in building another high level in the p/l curve. Before working with Peter, he had big problems adding on risk, and basically doing the same thing he was doing but in more size. P/l is just a function of size. Think about it once more;

“p/l is just a function of size”

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Analyse your p/l over and over again.

The above is the practical case study of a real live trader wring with myself as the risk “coach”. There are many ways to explore your p/l further.

Have you ever analyzied your p/l in reation to volatility as one metric?

Most traders make the best returns in higher volatiity markets. That is probably due to the fact that the more volatile the market is the more oportunities exist as markets become less “perfect”.

Below is how I started analyzing Peter’s p/l in relation to volatility, below expressed as the VIX index.

On a random year the p/l distribution was as per the below table per quarter that year as well as per month during that year. The quarterly distribution was for one strategy and the monthly for another strategy that were uncorrelated and both were market neutral.

You can clearly see that the more volatile the market was, the more money Peter was making. When you start analyzing the p/l like this, you will get much deeper understanding of how and why you make money.

One way to proactively think about optimizing your p/l is by starting to use “hedges” to your p/l itself as I briefly described earlier. When volatility surges the below table tell a clear story, you make good returns. Why not engage in selling volatlity when it surges, more like a hedge to your p/l. If volatility stays high, you will produce good returns trading, but if volatility falls, you will make money on the sold VIX “hedge” trade, and your expected trading p/l will be smaller, since your p/l is correlated with VIX.

Studying your p/l in depth will give you a much deeper understanding of how you produce returns and the risk an p/l management methodology will tell you when not to trade, and avoe all will tell you when to trade a lot!

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