Category: Risk Management

Taking the Shot

May 08, 2008

An excerpt I like from this article:

"When I need investing inspiration, I turn to "The Great One" -- but I don't mean Warren Buffett, Peter Lynch, or Benjamin Graham. And I definitely don't mean Jim Cramer. You've probably heard The Great One's name dozens of times, but you may not know just how wise he is. Nonetheless, he's said some very smart things. For instance ... "You miss 100% of the shots you never take" That's but one of the many pearls of wisdom The Great One has dropped over the years. And while it might seem obvious, or even trite, it's a truth we often take for granted. Just think of the person you never asked to the dance, or the job you never applied for, or the novel you never finished ... or the stock you never purchased. It happens to all of us. We get nervous, or doubtful, or busy, or ... you name it. And that might end up costing us the person of our dreams, or the job we've always wanted, or our only shot at fame. But in the case of investing, it will definitely cost us a fortune."

MF Global Announces $141.5 Million Bad Debt Provision

February 28, 2008

Opps!

Risk

December 03, 2007

An excerpt from an interview with Paul Tudor Jones II by Joel Ramin:

Q: How would you describe your general investment philosophy?

Paul Tudor Jones: I think I am the single most conservative investor on earth in the sense that I absolutely hate losing money. My grandfather told me at a very early age that you are only worth what you can write a check for tomorrow, so the concept of having my net worth tied up in a stock a la Bill Gates, though God almighty it would be a great problem to have, it would be something that's just anathema to me and that's one reason that I've always liked the futures market so much, because you can generally get liquid and be in cash in literally the space of a few minutes. So that always appealed to me because I could always be liquid very quickly if I wanted to. I'd say that my investment philosophy is that I don't take a lot of risk, I look for opportunities with tremendously skewed reward-risk opportunities. Don't ever let them get into your pocket - that means there's no reason to leverage substantially. There's no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.

Cut Your Losses

September 20, 2007

In the last few days I conducted on-camera interviews with both Larry Hite and Eric Bolling. Very different in their trading, but philosophically, they both beat home the big point: cut your losses and you have a chance. That reminder never gets old.

On the Outside of Hedge Funds Looking In

September 02, 2007

A great analysis about the game of governmental regulation over top investors. An excerpt:

"Why stop with hedge funds?" asked Kenneth A. Gruber, a professor of biological sciences at California State Polytechnic University at Pomona, Calif. He said if the SEC wants to be paternalistic it should look to protect investors from other risky investments, such as penny stocks. "Does any sophisticated investor [or the SEC] believe that penny stocks are a safer investment than hedge funds? I submit it is easier to lose one's shirt on penny stock investments than in hedge funds. Where will it end?"

Risk and Fear

February 21, 2007

Ed Seykota gave an insightful explanation on risk management recently on his site:

Risk is a combination of the possibility of a loss and the magnitude of the loss. We register risk in our bodies as a feeling of fear. One way to manage various forms of risk, including prospective risk, initial risk, open risk, and unconscious risk it to make sure your feeling of fear is an ally, fully functioning on your emotional instrument panel. In our medicinal culture, some people attempt to medicate fear, rather than manage risk...In general, people with willingness to experience fear and other feelings are better risk managers than those who have fear in k-nots or fear under the influence of narcotics.

A Betting Game

February 20, 2007

A good quote from Larry Hite:

“There are just four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all, because a success of that kind can encourage you to take more bad bets in the future, when the odds will be running against you. You can also lose a good bet, no matter how sound the underlying proposition, but if you keep placing good bets, over time, the law of averages will be working for you.”

Hedge Funds and Risk

October 25, 2006

A whitepaper (PDF) titled "Does a Change in Risk Regime Spell Trouble for Hedge Funds?"

Losses? Who Has Losses?

September 14, 2006

An old pro trader sent in a funny story about his days at Commodities Corporation:

"Back in the early 90's Commodities Corporation (CC) brought a few Japanese traders in for some in-house "training". Of course the ultimate and true goal was to capture some big Japanese money. I was still in their good graces and [CC] asked me to have lunch with a couple of these gentleman. They were new to the program and I hoped to give them some insight into how I handled the process of trading. I told them they had to come up with a method or system that fitted who they were. Then I told them I thought it was great to find a mentor and I was available anytime they had questions or issues and that is still me today. I then began to discuss how important risk management was and that I was willing at that time to risk only 1% per bet in dealing with public money. I am more aggressive today but that was then. I told them that losses were part of the process in finding winners. I will never forget as long as I shall live the youngest trader looked me square in the eye and with a very puzzled look asked "You have losses?" I knew right then these birds had a very long way to go and I often wonder what happened to them."

Perspectives on Risk

September 03, 2006

Michael J. Mauboussin excerpts (PDF) from a presentation at the Greenwich Roundtable on July 26, 2006.

A Culture of Risk

June 11, 2006

The odd thing about this article (PDF) describing Wall Street's culture of risk? Why don't the banks and other players have a plan to make money when shit hits the fan? Why is the unexpected viewed as something to manage and limit as opposed to being a great opportunity (trend following view)?

Article on "Risk"

May 20, 2006

A recent article of mine covering "risk" basics (PDF).

Risk and Volatility

April 04, 2006

Risk and Volatility are often confused. I have long had an article here about the subject. Adam Mann contributes this piece (PDF) about the subject too.

Ten Rules for Position Sizing

March 22, 2006

Ed Seykota was recently asked:

"If you could give me ten rules to consider with respect to position sizing what would they be?"

He responded:

"Ten rules for position sizing:

1. Bet high enough to make meaningful profits when you win.
2. Bet low enough so you are ok financially and psychologically when you lose.
3. If (1) and (2) don't overlap, don't trade.
4. Don't go adding a bunch of rules that don't work, just so you have ten rules."

Of course, Seykota and others will use detailed rules for risk management, that's not the point with his answer. I liked his #4 answer.

Bet Sizing Research

February 09, 2006

Michael Mauboussin of Legg Mason offers this recent research on bet sizing (PDF). An excerpt:

"Edge is key. Recall the foundation of Kelly's model rests on having a view that is different, and more correct, than that of the market. Having an edge requires understanding the market's perspective. As Poundstone writes, 'The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.'"

A Meditation on Risk

October 06, 2005

A Meditation on Risk appeas in Fortune magazine. A good line from the article:

"It is about how we cope with the realities of risk, uncertainty, and crisis. Often we simply don't: Risk taxes the wiring of our brains, reacting to a tangible present was far more important than planning for an uncertain future."

How Much?

October 05, 2005

A good refresher on some basic money management issues from Michael R. Bryant of Adaptrade Software:

"There are many different ways to vary the number of contracts or shares when trading. Some of the most commonly used methods, plus one variation on the fixed ratio method, are listed below:

1. Fixed number of contracts. The same number of contracts or shares is applied to each trade; e.g., two contracts per trade.

2. Fixed dollar amount per contract. A fixed dollar amount of account equity is needed for each contract or share; e.g., $5000 of account equity per contract.

3. Fixed fractional (also known as fixed risk). The number of contracts or shares is determined so that each trade risks a specified fraction of the account equity; e.g., 2% of account equity is risked on each trade.

4. Fixed ratio. The number of contracts or shares increases by one for each "delta" amount of profit earned per contract. For example, if the delta is $3000, and the current number of contracts is two, you'll need $6000 of profit before increasing the number of contracts to three.

5. Generalized ratio. This is a generalized form of fixed ratio, which includes an optional parameter to change the rate of increase in the number of contracts or shares with increasing profits."

Continue reading How Much? »

Risk, Reward & Margin

September 26, 2005

A good white paper on risk, reward and margin from David Harding and Winton Capital.

Kelly Formula, Bell Labs, Data Transmission and Optimal Bet Size

September 21, 2005

Read the new book Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone.

Review of book at BusinessWeek.

More on the Kelly formula.

Shrinking Risk - No.

September 16, 2005

A good quick read (PDF) about how rather than shrinking risk, the behaviour of following the herd by investors adds to it.

Risk Matrix: Speed v. Impact

September 11, 2005

The Risk Matrix: Speed v. Impact (PDF) is from Choice Alternative Investments.

Risk v. Volatility

September 09, 2005

Some feedback just received:

"Greetings, just a thought from another trend follower. I hear the term risk used by investors/traders all the time. They are rightly concerned about risk, yet most do not know the source of risk, and, therefore, how it must be handled. For instance, I spoke with an experienced trader today. One statement really stuck out, "...oil stocks are too risky just like the internet stocks from a few years back..." He then used this reasoning as justification for why he currently won't trade oil stocks. I tried to explain he was really talking about volatility - not risk. Stocks are not risky, they are volatile. Risk [on the other hand] is a part of one's trading system. How much capital does one allocate to the oil sector? When does one open a position in the oil sector? When does one close that position? If you know the answer to these questions before your trade, you have already taken steps to reduce your risk. Refusing to trade certain stocks, futures, commodities, indices, options, currencies, etc. will not accomplish this."

Money Management BS

July 06, 2005

I recently saw the following comment regarding money management:

"Every system in our report uses very simple money management: Trade one contract per trading signal in the markets specified by the vendor with no pyramiding."
Trading Guru

This is NOT money management. If you ever see anyone declare the above as money management walk away fast as you are about to be conned. Money management is not some set amount of shares or contracts picked out of thin air. Money management answers the question of "how much?" At all times, given the risk you are taking, the money you have, and the volatility of the market -- you must know the optimal number of shares or contracts to be long or short.

The Way We Live Now; See a Bubble?

June 18, 2005

Roger Lowenstein, who wrote the must read book When Genius Failed: The Rise and Fall of Long-Term Capital Management, offers some recent insight:

"In limiting risk, people also limit the opportunity for gain. It is common, today, for investors to own six or eight mutual funds, each of which is likely to be invested in hundreds of stocks. This will, they hope, assure that no little bump, no little meltdown, overly upsets their portfolios. But since when was investing about avoiding the bumps? Anyone investing for the longer term can safely ignore them."
The Way We Live Now See a Bubble?
Roger Lowenstein
June 5, 2005

Avoiding the bumps is exactly what trend followers do NOT do. They accept the bumps. Lowenstein continues:

Continue reading The Way We Live Now; See a Bubble? »

Ed Seykota Bet Sizing Article

June 10, 2005

A simple, yet classic piece of writing. Take a read of Ed Seykota's bet sizing article.

Balancing Out

May 03, 2005

When you trade as a trend follower, losses are often paid for with gains. Meaning there will be periods of up and down volatility with no clear trend directions. When the trends "hit" (something you can't predict), then the gains far out pace losses. Sunrise Capital offered the following commentary for March 2005:

"The Global Monetary Program declined 4.8% in March, as investor sentiment suddenly turned bullish regarding the U.S. dollar, resulting in sharp reversals in most currency markets and, to a lesser extent, metals. The ensuing losses from long positions in the euro, Swiss franc, Australian dollar and Japanese yen easily outpaced gains from long positions in Japanese government bonds and short positions in Eurodollars. The stock index and energy sectors posted modest losses as well...Long positions in crude oil had benefited early on from a perceived increase in global demand and a tightening of supply. On the 23rd, however, U.S. government data showed that crude inventories were, in fact, growing, and the market reversed sharply. Gains from long positions in metals also saw a turnabout led by gold, which reversed to the downside as the dollar gained strength after midmonth."
Sunrise Capital

Of course their fundamental analysis is after the fact and plays no role in their real-time decision making process within their trend following model.

Peter Panholzer on Risk

May 01, 2005

Peter Panholzer, a short term systematic trader, recently offered:

"We don't always understand that risk isn't always a money risk; there's the risk of regret. Sometimes you regret you haven't been in the market, sometimes that you got out too early or that you've taken a loss when it wasn't necessary. It's not only the money we worry about, it's also our regret we worry about."
Peter Panholzer

He continued:

"System trading is different from technical trading...In technical trading, you're reading tea leaves - the indicators. Interpretation of technical indicators is often subjective and not programmable. But you can program a system."
Peter Panholzer

High Sharpe Ratio?

February 03, 2005

Nassim Taleb was asked about common mistakes traders make. He responded to Derivatives Strategy with an answer useful for both beginner & expert:

"As a trader, my job is to understand biases and trade on them. There are all kinds of biases. The most common is the small sample bias. Let's say you have 1 to 1000 odds you will come home every day with a dollar and once in a while you lose $1000. Many traders show very steady incomes but they could be fooling themselves because they don't have a long enough period of time to chart their performance. Their Sharpe ratio will not be indicative. In option trading, there is a similar bias. Short premium option traders, typically those who sell out-of-the-money options, are more likely to make money on a daily basis and then blow up. Likewise the yield hogs, those traders who would take any risk for a few basis points. You can fool yourself with your Sharpe ratios, and you can fool all of the financial engineers, but you can't fool an old Chicago trader who went bankrupt twice. Another bias is what I call the size bias. If you have twenty thousand traders in the market, sure enough you'll have someone who's been up every day for the past few years and will show you a beautiful P&L. If you put enough monkeys on typewriters, one of the monkeys will write the Iliad in ancient Greek. But would you bet any money that he's going to write the Odyssey next? You know that because of the sheer size of the sample, you're likely to find a lucky monkey once in a while. But the same applies to traders."

The other day a reader asked me if trend following would beat his current strategy. He said he consistently makes +25% a month every month. Taleb's comments are useful for this individual.

Risk Happens

September 26, 2004

We can't avoid risk. It doesn't go away. Consider:

"Markets are an evolving ecology. New risks arise all the time."
Andrew Lo
CFA Magazine

The key to 'risk' is to make sure you have a plan to deal with the ups and downs before you start taking those risky behaviors.

Risk: What Exactly Is It?

July 16, 2004

Risk: what exactly is it? Ponder wisdom:

"Since we live in a world without crystal balls that allow us to clearly see the future, prudent investing is all about the management of risk and expected returns. A problem that both investors and investment advisors face is defining what exactly is risk. As you will see, risk can be many different things And since risk can be many different things to different people, investors/advisors are faced with deciding which risks are the most important to manage...Another risk that should be carefully considered is that of the unexpected negative surprise. Unfortunately, one of the most common and severe mistakes made by investors/advisors is to treat both the highly unlikely as impossible and the highly likely as certain. Prudent investors know that history teaches us that just because something has not yet occurred, does not mean that it cannot, or will not, occur in the future. One has to look no further than to the events of September 11, 2001 for proof of this important point. The potential for negative surprises should be built into any investment plan. Forewarned is forearmed. There is yet another risk investors/advisors must deal with-maverick risk. As Robert Arnott points out, "practitioners 'know' that the greatest peril is the risk of being wrong and alone. As such, we fall prey to the Keynesian dictum that it is more acceptable to fail conventionally than to succeed unconventionally. Decisions that leave an investor alone carry the inherent risk of being both wrong and alone. If an investor is wrong and alone, a strong likelihood is that the assets' owner will not have the patience to see the investment decision through. The decision, even if correct in the long run, will be reversed before it can succeed." We are all familiar with the expression "misery loves company." Experiencing relatively low (but still positive) investment results may create more psychological risks to the investment plan being abandoned than experiencing losses if everyone around is having a similar experience."
Paul Petillo

Charlie Wright on Risk Management

June 06, 2004

Charlie Wright of Fall River Capital paints a true picture of risk management:

"I often tell the story of the great fish restaurant that opened up just down the street from my office. It opened with great fanfare and was ranked in the top five restaurants in the city. The food was outstanding. But it only took a little more than a year and this great restaurant was out of business. Why? Because the key to running a good restaurant is not the food--it is cash management and risk control. It is making sure your business is run efficiently, keeping your costs (risk) in control, and managing your staff effectively. If you believe that the taste of the food is what makes a great restaurant, think of how great the food is at your favorite fast food restaurant. But, someday, watch how well that restaurant is run. Just as in the restaurant business, the key to profits in trading is not in the prediction or the indicator, but how well the trading strategy is designed and executed. The ability to achieve risk control and cash management will make the difference between a successful trader and an unsuccessful trader. If you ever have the opportunity to watch a successful trader, you will see that they don't worry about where the market is going or about predicting when the next big move will take place. They aren't looking to tweak their indicator. They are worried about their risk on each trade. Is the trade being executed correctly? How much of their total account is at risk? Are the stops in the right place? And so on."
Charlie Wright
Chairman of Fall River Capital, LLC

Charlie reminds us all that great decison-making is needed for running a trading firm or running a restaurant.

The Risk Debate

May 10, 2004

I had conversations with two groups today. One group runs a fund that combines many traders together into a portfolio that aims for good returns, but less drawdown. The other group works with a trend following legend who shoots for absolute returns. Is there a right direction? Should you as a trader (or investor with traders) have multiple trading approaches combined or one great absolute return strategy? It is an interesting (and useful) debate. There will always be fierce arguments from each side for their point of view, but the choice ultimately comes down to what you want in your life and your performance.

Results with No Risk?

April 29, 2004

It seems everyone wants the results, but not the risk. However, we all know it doesn't really work that way (even if we refuse to admit it). David Harding, Managing Director of Winton Capital Management, put it in perspective in a January 2004 interview:

"...hedge fund management in general, is not a traditional asset management business it is a risk management business. An investor should be hiring us to take risk on their behalf, and we will take exactly the level of risk that they ask for. For example, if an investor...asks us to produce annual variance of 1 per cent...we will do it and we will get it exactly right. In contrast, returns are not predictable!"

That is the rub. Everyone wants the big returns, low risk and a nice orderly return profile of 2% a month performance, but the real world never conforms to that ideal!

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