Download (direct link):
Of course, stress testing has its own weaknesses, including the fact that neither hypothetical nor historical scenarios has any significant chance of resembling actual future price shock events (and therefore our protective risk management measures might prove quite ineffectual). Nevertheless, because stress testing can incorporate breakdowns in historical correlations, liquidity risk, cumulative losses, and clustering, it remains particularly valuable as an adjunct to VaR analysis. In fact, stress testing compensates for so many weaknesses in VaR methodologies that together it and VaR are viewed as two halves of a single school of price risk management.
PSYCHOLOGY OF PRICE RISK MANAGEMENT
Because the amount of risk that we are willing to assume is the only essential aspect of trading over which we exercise complete control, we can never be too diligent regarding price risk management. Why do successful hedge fund managers consistently show average annualized returns of between 5 and 25 percent? Obviously they could show average annualized returns of 50 to 250 percent, but this would greatly enhance their likelihood of ruin. One of the most common reasons retail and institutional traders fail is their lack of adherence to comprehensive, systematized price risk methodologies. This lack of adherence invariably manifests itself through their overleveraging of equity under management.
MECHANICAL TRADING SYSTEMS
Although other factors may lead to our inability to “pull the trigger” on a trade, one of the most prevalent and sensible reasons is that we are risking too high a percentage of our total equity on a per-position basis. We should be hesitant to execute a trade if such an action could lead to the end of our careers as traders. This is simple self-preservation. If, prior to execution of a trade, traders are overwhelmed with anxiety, they should ask themselves if suffering a loss on this anticipated position would impede their financial ability to trade in the future. If the answer is yes, they should trade small enough to ensure that this would not be the case.
Our culture thrives on immediate gratification. Microwave ovens, airplanes, fad diets, T1 lines, fast food restaurants, and the like all address this need for speedy solutions. Part of the attraction to leveraged financial instruments is their ability to satiate our greed and impatience as traders by getting us rich quicker. Instead I admonish readers to get rich slowly and safely. Compare the rate of return on leveraged instruments to those of competitive investment vehicles. If it is considerably greater, compare the risk of ruin. Ideally, prudent price risk management should reduce the risk of ruin on leveraged assets to a level similar to that of nonleveraged instruments.
Other techniques to aid with the psychological problem of trigger pulling include risking only that capital that we truly do not care about losing. Only risking capital we can afford to lose is actually quite similar to a disclaimer adopted by brokerage firms making markets in leveraged instruments. It is much easier to practice nonattachment to the results of our actions in the market when we are not emotionally or psychologically attached to the funds being placed at risk at the endeavor’s outset.
Prior to our assumption of a position in the markets, we should be able to answer these questions in the positive: Do I have adequate capital under management to weather a peak-to-valley drawdown in excess of the worst severity shown throughout my system’s backtested history? Have I accounted for slippage/commissions in the event of a price shock event? Am I psychologically and financially prepared to exceed the largest number of consecutive losses endured by my system during its backtested history?
MECHANICAL TRADING SYSTEMS, DRAWDOWNS, AND TRADER CONFIDENCE
Mechanical trading systems can prove invaluable in the implementation of the various price risk management tools discussed in this chapter. Because such systems enable us to quantify risk on both a per-asset as well as a portfolio-wide basis, they are essential in the establishment of stop-loss levels, volumetric position sizing limits, and risk/reward estimates. Another, per-
Price Risk Management
haps even more important benefit of mechanical trading systems is their ability to instill trader confidence during periods of equity drawdowns.
Drawdowns in equity under management are a fact of life for all traders. How traders handle these tough times ultimately will determine the degree of success that they and their portfolios will enjoy. A key to successful trading during equity drawdowns is the maintenance of consistency and discipline. Although it is never easy for traders to stick to rules of entry, exit, and risk management after suffering a string of losses, because mechanical trading systems are backtested prior to the commitment of capital, both portfolio managers and the investors they represent should enjoy greater confidence and tempered emotionalism during these inevitable periods of drawdowns in equity.