LEVEL: ADVANCED
Investing in capital markets requires a sound strategy that manages for risk in order to achieve sustainable and strong returns without significant losses. Risk management as it pertains to individual trades focuses on the exit point of a trade which is somewhat different to the bet size. It is also different from managing the risk of an entire portfolio. The focus of this article will be on examining how to understand risk and what techniques can be used to generate robust returns.
The Plan
Money management techniques are geared toward delivering risk-adjusted returns based on a reasonable bet size and a view of the overall risk of a portfolio. This concept can be broken down into the expected gain or loss on a trade as it relates to the actual returns on a trade, along with the potential bet size for each trade.
The Bet Size
Determining the optimal notional value of a transaction is a key component to generating a profitable trading strategy. Creating and following a trading plan helps an investor preserve capital and avoid risk or loss of capital. In an effort to determine the optimal notional size of a trade, analysts have used statistical models such as Monte Carlo simulation along with the Kelly rule. A Monte Carlo simulation allocates capital to a strategy and will test this allocation by randomly testing the allocation using a series of simulated data.
There are a number of styles that can be used to allocate capital effectively. One style is to allocate a fixed notional amount in which an investor allocates a specific amount of capital per trade. This method can become ineffective as the amount of trading capital increases or decreases over a period of time.
The advantage of a fixed style of fund allocation is that it mitigates an investor’s chances of losing all capital by reducing the bet size as the amount of capital in a portfolio decreases. The strategy also benefits with larger bet sizes as the capital in a portfolio increases.
A pyramid strategy increases the bet size in percentage terms as the portfolio climbs, and decreases the bet size as the capital base falls. This strategy is best suited for trend following strategies as it optimizes allocation as a trend perpetuates.
With all allocation strategies, avoiding ruin is the most important aspect of risk management. In all strategies, it is important to determine the capital allocation prior to the onset of the strategy. For example, assume an investor’s goals are to generate returns of 20% within a year with a strategy that allocates 12 trades throughout the year. The strategy is believed to win 50% of the time and wins twice as much as it losses on each transaction.
A capital allocation that risks 4% for every 2% risked will generate a return of about 10%. (10,000 * 1.04 = 10,400 * .98 = 10,192 * 1.04 = 10,599 * .98 = 10,387 * 1.04 = 10,803 * .98 = 10,587 * 1.04 = 11,010 * .98 = 10,790 * 1.04 = 11,222 * .98 = 10,998) This type of analysis is very important in determining the correct amount of risk to allocate to a trading strategy.
When beginning the process of creating a strategy, regardless of whether the trading strategy is a systematic or discretionary strategy, it is very important to create a plan on how to manage your capital in a pre-defined way.
Designing a money management plan is the most important concept, as it will determine whether a strategy will generate returns over the long term. Preservation of capital is the most important aspect associated with money management.
Strong money management will give an investor the time needed to determine if a trading strategy will be successful. Usually during the course of testing a trading strategy in real time, an investor will face a decision on whether to continue despite the lack of success. Solid risk management will allow an investor to give the strategy enough time to determine if it will return the desired returns that meet the investor’s goals.
Portfolio Management
Part of portfolio management is determining the correlation of returns between different strategies. Generally investors like to utilize similar strategies that will generate similar returns in specific market environments. Unfortunately, this also means that highly correlated strategies will also lose money at the same time. Investors should look to employ strategies that have returns that are uncorrelated as it will allow them to make money in many different market environments. For example, if an investor has 5 strategies and they are all highly correlated, 5 positions with the same type of return profile could easily lead to ruin at the same time.
Hedging a Portfolio
Mitigating the risk associated with a portfolio prior to an adverse move is a strategy that investors can employ to hedge exposure. In many cases, an investor will use broad market indices or even options to hedge their exposure to a broader market movement.
Investors can hedge their exposure to a strategy by reducing their bet size on positions, or using financial instruments to mitigate their risk. Investors will often hedge their positions when the risk of a large market move is possible given a specific fundamental event (such as a earnings released or monetary policy report).
Investors can use short positions on broad market indexes to hedge exposure. For example, an investor who is looking to hedge a position of large cap stocks could consider shorting the S&P 500 index as a proxy for their portfolio.
Other types of hedging strategies include purchasing protective puts or selling calls or a combination of the two which is referred to as a risk reversal (selling a call and buying a put). By purchasing put options, a trade can mitigate the directional risk in the market if he owns a long position. Similarly, the trader can buy call positions to mitigate the risk on a short position.
Clearly portfolio management is one of the keys to a successful trading plan. Investors should examine the specific bet size to use in a effort to optimize their trading strategy and produce robust long term returns.