Thursday, May 2, 2013

Risk limits are simple and effective

There is so much focus on finding opportunities for a positive E(PnL) (statistically expected Profit & Loss) that risk management research effort has become unsexy. Analyzing historical trading performance, I've noticed that setting daily risk limits would have improved over all returns significantly. The fact remains that effective risk management can actually improve business performance over time.

Positive kurtosis in financial returns

Empirically evidenced, financial return distributions, individual products or spreads, tend to display very positive kurtosis which suggests heavy tails. That is to say, average prices move turn-around points are impossible (for most of us) to predict with accuracy over time, hence the "falling knife" phrase for those trying to buy the bottoms or sell the tops.

Therefore, if a position displays an unrealized net loss and is left alone, the momentum could keep moving until the trader loses his/her shirt. This is how some of biggest losing days I had experienced, and learned from.

Daily risk limits 

Applying a strict daily risk limit is simple to implement, effective over time, and puts you closer to a professional level. That means as soon as open positions reach a certain threshold intraday, everything must be liquidated/hedged to stop the bleeding. Even for buy & hold guys, a risk limit could have significantly reduced draw downs in high volatility periods.  

If this doesn't make sense, then it is pretty obvious that a deep understanding of stats is necessary to become a profitable trader.

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