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Consequently, I strongly recommend that the Sharpe ratio be included in tradersâ€™ performance results while it is simultaneously supplemented by the more robust measure of the profit to maximum drawdown ratio. Because the P:MD is not yet a universally accepted measure of system analysis, the trading philosophy statement should explain why the P:MD ratio is included and why it gives a more comprehensive exposition of the true risk/reward dynamics of the systemâ€™s performance.
Price Risk Management
Schools of Price Risk Management and other Considerations
Iâ€™m not afraid of storms, for Iâ€™m learning how to sail my ship.
â€”Louisa May Alcott
PRICE RISK MANAGEMENT ISSUES: AN OVERVIEW
Although price risk management will not turn a losing trading strategy into a winner, it is arguably the most important topic in this book because it can prevent the failure of an overall profitable trading system. Imagine a system that produces an astonishing 90 percent win/loss ratio, and pair this system with a trader who commits all accumulated profitsâ€”along with the original stakeâ€”to the next trade. According to the laws of probability, on average, such a trader would end up broke by the termination of the tenth position.
The other reason why I believe price risk management is such an important tool in the traderâ€™s arsenal is that we can never control the markets, only how much risk we will assume in them. Because we can never know with certainty whether any particular trade will result in a profit or a loss, it is the height of folly to focus our attention and capital on those aspects of trading over which we have no control while simultaneously neglecting price risk management, the one essential aspect of trading over which we exercise absolute control.
Of course, we do also have control over which entry point we choose for any particular trade. However, the selection of precise entry levels probably represents the least significant aspect of a successful trading system. In his book, Trade Your Way to Financial Freedom, Van Tharp illustrates
MECHANICAL TRADING SYSTEMS
the lack of importance of precise price entry levels chosen in the development of a successful trading methodology by outlining a system Tom Basso, a trader interviewed in Schwagerâ€™s The New Market Wizards, developed based on random entry signals.1 Nevertheless, novice traders and system developers continue to focus their attention almost exclusively on selection of trade entry points because it represents their â€ścontrolâ€ť in the markets; simultaneously they ignore the psychologically uncomfortable issue of losses and price risk management.
Many books on trading, system development, and technical analysis include sections entitled â€śRisk Management.â€ť In reality, these books almost always are referring to the need to manage a specific type of risk, namely, price risk. Market participants need to manage various other types of risk as well. Some, such as liquidity risk, are addressed in this chapter, due to their critical and universal effect on issues of price risk management. For a discussion of other types of risk management, such as credit and operational risk management, see Risk Management by Crouhy, Galai, and Mark.
During the early years of my career as a trader, Refco, one of the larger exchange-traded derivatives brokers, used â€śRisk Is Everywhereâ€ť as its advertising slogan. I have always liked the phrase because it succinctly dispels one of the great myths of investing, namely, that we can somehow avoid financial risk. This myth suggests that investment vehicles that do not guarantee a return of principal are risky and that we can somehow avoid risk by putting our money under the mattresses, in a bank, or in T-bills. Obviously, investing in vehicles that do not guarantee a return of principal entails greater risk than those that do; however, in choosing investment vehicles like T-bills, we end up accepting the opportunity risk inherent in our forfeiting a potentially higher rate of return.
This comparison of guaranteed return of principal investment vehicles with â€śriskierâ€ť investment alternatives illuminates an inescapable law of investment: The higher the risk, the greater the reward (and conversely, the lower the risk, the lower the reward). Promises of high reward and low risk suggest three possibilities:
1. The probability of realizing this high reward is remote enough to compensate for its relatively low level of financial risk (e.g., lottery tickets, deep out-of-the-money options, etc.).
2. The entity proposing the investment lacks a fundamental understanding of the true risk/reward entailed in the investment vehicle.
3. The entity proposing the investment understands the true risk/reward but is attempting to hide these realities (e.g., fraud, money laundering, etc.) from prospective investor(s).
Price Risk Management
STOP-LOSS PRICE RISK MANAGEMENT FOR TRADING ACCOUNTS
Obviously traders can improve their systemâ€™s rate of return simply by increasing the worst peak-to-valley drawdown levels allowable. For example, let us assume $100,000 under management and that our trading system executes single contract positions on a given portfolio. Based on this criterion, we discover that our system endured a worst peak-to-valley drawdown of $20,000 or 20 percent for our portfolio. Consequently, as long as we are willing to weather a 40 percent worst peak-to-valley drawdown in equity, we could double our average annualized rate of return simply by trading two contacts instead of one.