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Practical Risk Management 1

Risk and p/l management is great, but how do you do it practically?

By now you have hopefully read the market psychology article, giving you an insight into the complex area of psychology, markets, the decision process and all the other aspects of both the individual as well as the aggregate psychology of investors.

It all boils down to the risk management methodology I have developed over the years. The methodology offers a totally objective way to handle your risk and optimize your trading and p/l.

Aleksandar Adamovic

pro MEMBER SINCE 2018

Aleks has over 20 years’ experience working in the financial markets, having worked at the trading desks of Merrill Lynch and HSBC before becoming the youngest ever head of trading at Carnegie Investment Bank.

20 min read 22nd of Oct, 2019
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By now you should know that trading is an extremely complex and demanding ”profession”. Done properly, it brings out the best in you, done poorly, it will not only bring out negative p/l, but also make you low and depressed.

Personally, I have experienced all phases of trading during my life, and the biggest conclusion is to set up a methodology that works and is objective. Relying on hope, luck and other fallacies, I leave to others.

Below is how I go through and set up practical coaching of traders. I have worked with many traders and portfolio managers over the years. The first aspect when meeting and starting working with new traders is that they must be open to improving their trading and the vital part is to have an open mind about your trading and have the willingness to develop as a trader by deep diving into your own psychology and be open about changes.

Before going into a ”live” study of how you can work with improving your p/l eventually, you need to try to answer some questions in an open and honest way. Being honest to yourself is the first start you must go through and it is crucial to be totally transparent to yourself.

Practical Risk Management

Below are the vital questions to be answered by yourself. I have filled out answers by one of the traders I used to work with for years as an ”external head of trading”. This trader is one of the most disciplined traders I have ever seen, but even this guy had a lot of improving to do.

Recall the good and bad trader types I referred to, this guy is the good trader with a stable p/l, a natural stop loss, but he lacked the ability to take his p/l to new plateaus. This is a classical problem where people are afraid of taking on more risk. Bigger positions usually ”scare” this type of traders, limiting themselves from the ”parabolic success”.

Below are the questions vital for everyone that wants to start a serious approach to his/her trading. I have added my own comment after every answer and suggestions on what areas to work with in order to improve results.

When do you lose money on your trading?

  1. When I deviate from my strategy.
  2. When I think trading is doing ”great”.
  3. At turning points in markets.

My comments: set up rules so you do not deviate from your strategy, do the work before trading.

There is a classical problem of small hubris here, where people often start deviating from the strategy when they are doing ”great”. Be objective and do not feelings take over your trading. Doing great is just a figure at the end of the day. You are not smarter, not more valuable as a person or anything else just because your trading is doing great. Feelings of trading ”great” often result in poor p/l periods, just as the trader above states.

Turning points is often a hard time for people trying to catch trends as in the middle of the turning point there is no real trend. This is often common for people to lose money when markets start turning. Be aware of this and learn how to identify these turning points.

Why do you lose money on your trading?

  1. When I was ”wrong”
  2. When I do something without an edge
  3. When I do not have an edge, but start ”producing false edge”, i.e. fooling myself having an edge

You can’t ”hedge” being wrong. The good part with this trader is that he has a ”natural” stop loss level built into his mind. Being wrong is an everyday feature of trading.

Doing trades without an edge is different. Good traders know their edge and stick to trading their edge. Theoretically you should not be engaging in trading without the edge, so the only thing here is to stop the ”sloppiness”. The third point of producing ”wishful” edges is dangerous. Be sure to write down what are your edges and stick to these. Never start trades and developing edges during the day. Your trading edge should be predetermined, whatever it is, but should not be ”artificially produced”.

What do you do when you lose money trading?

  1. Reduce size
  2. If the loss is within ”loss bands” I do nothing

This is a great answer, always reduce size when you start losing money, but as my methodology states, you can’t stop trading unless your p/l starts breaking below the moving averages (that you should have studies and should be put in place prior to trading).

Normal losses are a normal part of trading, so you should never ”panic” about this, just keep it controlled.

When do you make money trading?

  1. When I was right.
  2. When things are moving.
  3. When others are losing.

Making money when you are right is not a great answer. Of course, it is not a surprise to make money when right, but you must analyse much more. How much do you make ”extra” when being right? Do you add risk and ride winners?

Volatility is usually correlated with positive p/l for most private traders. This is mainly a function of higher volatility creates opportunities. I will come back to this, but one way to use volatility in your trading is ”hedging” your p/l. Think about it, if you make a lot of money when volatility is high, why not trying to sell short VIX as one trade to ”hedge” your p/l should volatility decrease suddenly.

Why do you make money trading?

  1. I have an edge
  2. Disciplined

These two answers are very wise and key to long term profitable trading. Discipline is extremely important. Edge is an important factor as well, but even more than edge, is to have a rigorous risk management method.

What do you do when you make money?

  1. Give myself something nice at year end
  2. Nothing special if it is just a good day
  3. Focus even more on the ”stuff” making me money

Rewarding yourself when you make money is dangerous. People tend to relax when they make money and decide going for holidays and enjoying other treats. This is absolutely wrong. When you are hot and make money, stay in the zone and trade as much as you can. It is during these periods you will lift your trading to new levels.

Why do you trade? What are your goals with your trading?

  1.     It is my job
  2. It is my hobby and major interest

Making your hobby to a job is great. What you do not want is to have only money as a goal or even worse, trade because you need to make money. I have met traders that are squeezed financially and ”must make money”. This is a no-go zone because it always ends in tears.

What products do you trade?

Equities, futures, options and FX (fx just as hedging tool).

Nothing more than make sure you know your products. Also, if you use FX for hedging purposes only, do not start to deviate from the strategy and start ”having views” on currencies, unless it is your strategy.

How many positions do you hold?

Maximum of 3-4 positions.

Some people can handle many positions, but be honest with yourself, how many positions can you focus on. Personally, I think, relatively short-term trading, often allows you to focus on a few positions at the same time only unless you are running algos that trade various strategies with computers.

 What is your average holding rate?

I hold my positions between 1 hour to 6 hours.

This is something you should know and track, but there is no right or wrong.

Do you trade ”relevant” products?

Both yes and no. At times I have a view on oil, but express it in oil stocks for example, and this is sometimes not great.

Trading the relevant product is key to most traders. Way to often do I meet traders that have a view on say oil, but they are equities traders and end up trading oil stocks. Frustration arises when their oil call is right, but they traded the view in oil stocks that happened to move in the opposite direction to oil. Trade the relevant product!

P/L Management

Do you use leverage?

I should use more, but I am ”scared”.

Traders are usually scared to deploy more leverage, but this is only because they have a problem controlling the volatility in the portfolio. Leverage can kill you if you use it without a proper risk management, but if used well, it will produce the new plateaus of p/l and develop you as a trader.

Do you want to expand your risk taking?

Yes!

Most people want to expand, but do you have the tools to expand. Do you have the proper risk management methodology in place before you expand?

What are you happy/ not happy about with your p/l?

I am happy my trading is disciplined and controlled but not happy I cannot take it to new levels. I feel I am too disciplined.

This is both great and not great. Having discipline is great. This usually comes with traders that do not like volatility and have a very good ”natural stop loss” mentality. The biggest problem with these stability traders as I sometimes call them is that they lack the relevant mindset to take on more risk, apply a rigorous risk management and really lift the p/l to a new level.

What is a normal loss day for you? What is normal profit day? What are extremes?

Loss 15k, profit 10k. Extreme is 4 figures, both ways.

This is of course individual in relation to your book, but be sure to put these figures down.

How big drawdown is ”ok”?

At the moment 15k, but I can take easily 25k without ”freaking out”.

Another important figure to put down on paper. Recall when you are in the comfort zone and when you are outside the comfort zone. When drawdowns start becoming too big, there is usually something wrong so be sure to address whatever might be the problem before you create more negative p/l.

What are the risks in your trading?

I want to be able to exit all my positions in one day and I would not be out of business should a long/short do a black swan move.

This is another individual metric, but to be able to trade out of your positions in a day or two should be something to strive for. We have seen several funds crash due to liquidity. You do not want to be stuck in positions you cannot exit because of liquidity issues. Whenever you are stuck you have overseen your rules and this leads almost always to big uncontrollable losses. We do not want those situations.

Over time having a profit warning or a bid move against your position should be 50/50, but never should one possible event wipe you out, so have a position in accordance with that rule.

What kind of risk management methodology do you use? Do you have a sound management of risk?

Max position with a “bust/bid” risk always in mind.

Liquidity is of extreme importance to me.

This is close to the previous question. Having the above is a good start, but you need to apply the risk methodology I have outlined in order to gain full control and optimize your trading.

How do you feel when you make/lose money?

If I am +-25k and I traded according to my plan it does not affect me at all, irrespective if I made or lost, my objective is to trade my plan.

I like to keep my losses small unless it has been an extreme period.

Most people feel strong emotions when they lose money, but I will keep on coming back to this point, losses are the most natural part of trading. If you accept losses as a natural part of your trading, then you will not be emotional about it. You only need to control the p/l and emotions will follow, i.e. you will treat losses without emotions.

risk management methodology

Do you have an edge in your trading? What is your edge?

Yes, my edge is in trading spread, often in stocks dually listed in various time zones. I am good at identifying flow in these types of names.

All traders need an edge. The edge can be practically whatever but you need to define what you are good at. Trading without an edge is dangerous as you will eventually end up trading setups without an edge, and we all know how things end if you do not know how to do them.

Do you develop your trading when your ”models” work/ do not work well?

I took it to one level but have stagnated in developing new ”models”.

Adapting and reinventing yourself is crucial to most things you do in life and is applicable to trading as well. Strategies I used to trade 20 years ago do not work these days for several reasons. Market microstructure has changed, central banks are active etc are all aspects of the market that constantly change. If you do not adapt to these factors, your trading will slowly implode.

What is ”development” for you? What motivates you?

Development is to think and implement practically that you have not before in trading, do something better and cheaper is key to me.

I am motivated by security rather than ”greed”. Trading is the only thing I do and the only thing I want to do.

This touches upon the previous question. Always try to develop and improve your trading. Adding another broker, platform, asset or whatever could be a success factor. It is also very important to understand what motivates you. If your motivation is to play soccer for a professional team, you really need to train hard, eat right, have the mental approach etc. The same applies to trading.

What do you want to develop in your trading?

I want to develop skills and a method that can help me achieve better p/l and a more controlled feeling when it comes to the risk I am running.

Many people want to develop systems and models, but they fail to understand they need a robust risk management system first. Be kind to yourself, spend time on the risk management, the rest will follow.

Do you need to change your risk taking in order to achieve higher p/l? Are you willing to do that?

Increase size, work harder with limiting losses.

More automatic trading, more strategies.

The important question to ask yourself here is ”are you willing to do that”! People want to make more money, but they often do not want to do what is needed to be done to reach that goal.

What is your turnover per day? How does p/l correlate with turnover?

1 euro per day.

I do not think so.

This is an important factor to study closely, especially for shorter term traders.

What is your average holding period? Correlation with p/l?

5-6 hours. It does not correlate with p/l, I trade constant amount of stocks.

Bear in mind my biggest p/l occurs overnight.

Another important factor to watch, correlation between holding periods and p/l.

What is your stop loss methodology?

If my edge vanishes, I close.

Never more than 3 days down.

After 1 minus day no more overnight.

This trader has a very natural approach to stop losses, but as you have seen, he lacks the ”dynamic” risk and p/l management approach I have outlined. It is great to have the natural stop loss mentality, but even easier is to simply use the risk management methodology and let the moving averages control your risk. It is totally objective.

stop loss methodology

How often do you ”stare” at your p/l?

I know my p/l at all times.

Many traders focus on the p/l and too much focus on intra day p/l can often have a limiting effect on your trading. Look at the p/l, but do not become obsessed with the p/l during the day.

What is your time horizon? Do you have multiple strategies?

Max 1 day. I run a few strategies but would like to expand this.

Predefine this and stick to the plan. You can later change the plan, but only if you have considered it properly.

How often do you adapt your trading to current levels of volatility?

I take down risk, but not automatically.

Higher volatility means more gyrations and per definition you will produce more profits or losses. In order to have the same p/l swings, all things equal, you need to adjust your risk in accordance to volatility. My method of moving averages dictating the risk will take care of this problem automatically.

Do you trade multiple ”dimensions”? For example, short SPX, but volatility high so you sell VIX?

No, I do not, but open to suggestions.

Truly good traders know every aspect of their p/l so they master even ”hedging” the p/l from the aspect of knowing how and when they make money. As I mentioned earlier, imagine your p/l is doing well in terms of elevated volatility. Many times, active traders find good ”dislocations” when volatility is high and produce good p/l. Imagine if volatility is high and your making good money, but you know volatility will eventually come down. One way to ”hedge” your trading is by selling VIX or other related volatility instruments. It might sound crazy, but the best traders I know often do think in these terms.

They master their trading and their risk, they know how their p/l is produced and they know every single piece about how to optimize their performance and results.