Trading Risk

Enhanced Profitability through Risk Control

Kenneth L. Grant

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118045824
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Revolutionary techniques that traders can implement to improve profits and avoid losses

No trader, professional or individual, can afford not to have a solid risk management program integrated into his or her trading system. But finding a precise mathematical model to replace subjective decision-making processes is a challenge. Traditionally, risk management has focused solely on loss avoidance, but in Trading Risk, hedge fund risk manager Kenneth Grant presents some-thing completely new—how to manage a portfolio to minimize risk and increase profits by putting more capital at risk. Trading Risk details a risk management program that can help both money managers and individual traders evaluate which elements in a portfolio are working efficiently and which aren't. By illustrating an extremely simple set of statistical and arithmetic tools this book can help readers enhance their performance in many financial markets.

Kenneth L.Grant is Cheyne's Global Risk Manager, and is the Managing Member for Cheyne Capital, LLC, the firm's U.S. arm. Mr. Grant is a pioneer in the field of hedge fund risk management and capital allocation. Before joining Cheyne, he created risk control programs at two of the world's leading hedge funds, Tudor Investments and SAC Capital, where he was eventually promoted to the title of Chief Investment Strategist. Mr. Grant holds a Bachelor of Science in Economics and Mathematics from the University of Wisconsin, an MA in Economics from Columbia University, and an MBA from the University of Chicago Graduate School of Business.

CHAPTER 1

The Risk Management Investment

Once a jolly swagman camped by a billabong, under the shade of a coolibah tree, and he sang as he watched and waited ’til his billy boiled, you’ll come a-waltzing Matilda with me.

Waltzing Matilda, waltzing Matilda, you’ll come a waltzing Matilda with me. And he sang as he watched and waited ‘til his billy boiled, you’ll come a-waltzing Matilda with me.

—“Banjo” (A.B.) Paterson
“Waltzing Matilda”

In the words of a famous and well-compensated but (perhaps understandably) anonymous economist, “market prices tend to fluctuate.” I know this to be the case, for I have witnessed such fluctuation firsthand. Perhaps you have, too. Furthermore, I think we can agree that this, on balance, is a good thing. It’s certainly beneficial to my business, and I believe it is to yours, as well. However, I don’t pretend that this little bit of philosophy will offer much comfort to you when said price movement adversely affects your portfolio—particularly if, as often is the case, the movement is significant and abrupt and occurs without warning. Still, I encourage you to bear in mind the big picture the next time your favorite stock preannounces bad earnings. And also, come to think of it, do the same thing when your other favorite stock preannounces a good number, because you are much more likely to attribute this to your own shrewdness than you are to a lucky roll of the dice.

The truth is that market risk, like the very oxygen that we breathe, remains ubiquitous, necessary, and (oftentimes) unnoticed in the world of portfolio management affairs. Our mission, whether or not we choose to accept it, will be to manage this risk. If we do this job well, it’s a fair bet we will be rewarded; if not, we are highly likely to suffer a penalty. Daily I hear from the traders I manage, “Don’t worry, Ken, of course we will manage the risk. After all, we’re professionals.” Fine. Good. Perfect. Only there’s one problem: Risk management costs money (or were you under the impression that I do this for my health?). Risk management verily hovers over the portfolio management process, reminding you of its presence and making demands at the most inopportune times. During periods of healthy performance, its unrelenting protocols nag at you in a very bothersome manner. When performance suffers, the steps you neglect to take in its name often fall under the heading of “too little too late.”

Like highly personal physical exams my fellow baby boomers have the honor of receiving on an annual basis, risk management is a costly, often unpleasant (not only for the recipient, but also, I assure you, for the practitioner) exercise that, if performed regularly, can help prevent nefarious outcomes. My doctor, who is nothing if not a salesman, encourages me to view these procedures as an “investment” (or did he say “intervention”?). That the exercise costs me (in addition to a modest loss of dignity) nothing more than a nominal co-payment is an indication that my insurance company agrees with this characterization. Lying on the examiner’s slab last year, eagerly anticipating our annual bonding ritual, the parallels between what lay in store for me and the services I perform on a professional basis really hit home.

And so it is partly as a tribute to my doctor that I call this chapter with which we’ll begin “The Risk Management Investment.” Risk management is an investment; and the more you think of it in these terms, the better off you’ll be. As with any investment, it requires the allocation of scarce resources, for which it is reasonable to expect a return. I’m biased, but I believe that a wellconceived and efficiently executed investment in a risk management program ought to generate as healthy and steady a return as anything that’s likely to make its way into your portfolio. And I heartily recommend that the next time the invisible hand of risk management finds its way into your nether regions, just do like I do: Close your eyes, repeat over and over again “It’s an investment,” and wait for the returns to come rolling in.

The Risk Management Investment will insinuate itself into your otherwise tranquil portfolio management existence in myriad ways. For example, you’re almost certainly going to have to map your returns through a series of risk metrics that offer perspectives that differ materially from the ways in which you might otherwise view your overall performance. If you are a professional money manager, this measurement system is likely to be designed by others and will invariably, from time to time, yield results that seem counterintuitive. Indeed, as we will discuss later, your employing institution may have viewpoints on how to best measure and control risk that may differ from yours and may impose constraints on you that actually interfere with your ability to efficiently manage portfolio exposure as you see it—even when you are operating with the purest of risk management intentions.

The mapping of your portfolio into risk estimation mechanisms is also likely to require some computing power, data inputs, and other resources for which the providers tend to charge a fee. Either you or someone you pay is going to have to understand this output, at least at its most superficial level. If this person does happen to be you, the time and energy that you apply to these activities will come at the expense of other uses you might have in mind for these most precious of your resources.

However, all of these commitments are minor when compared to this most important, capital-intensive element of the risk management investment process: its impact on your portfolio management decision making. Specifically, your success from a risk management perspective will be determined by your willingness and ability to effectively adjust your portfolio in ways that serve the objective of risk control and capital preservation and that will, at times, run counter to the actions you would take if you were not constrained by a finite capacity to sustain losses. These adjustments, to be sure, will occasionally cost you money, but I’m confident that not making them will cost you much, much more.

My guess is that just about everyone who has read this far agrees with this general premise. However, we will be seeking more than moral victories from here on. Specifically, now that we’ve agreed that a solid, comprehensive, and consistently applied risk management program is a good idea, we will devote the balance of our time together developing such a program, the objective of which will be to provide you with the means to

• Establish rational and effective risk parameters for your account.

• Measure your exposures against these parameters.

• Identify the various alternatives in the marketplace to adjust your exposures, should you deem it advisable to do so.

• Pinpoint the specific situations that call for such adjustment, as well as the psychological and market-based obstacles that might interfere with your ability and/or willingness to make such adjustments—even when they are critical to your financial well-being.

As part of this process, we will develop a statistical tool kit, which will provide a simple, quantitative framework for both risk management and performance assessment. Certainly, this tool kit will not make us omniscient: We won’t be able to predict with precision exactly what will happen to a portfolio every single time it is subject to market events—any more than a heart surgeon can forecast the precise sequence of events that take place each time he or she opens up someone’s chest. In both situations, there is an ability to estimate a range of outcomes, along with associated probabilities, given a careful reading of internal and external conditions. Moreover, in either case, while the outcome of any single intervention (into the portfolio or the chest) cannot be engineered with certainty, it’s a fair bet that practitioners who use available empirical information as the basis for decision making will achieve favorable outcomes more often than those who don’t. Over time and across situations, more heart patients survive and, in a similar fashion, more market portfolios are rendered much healthier—each by using techniques of simple statistical estimation that are based on inputs derived from empirical data.

However, while no one dares to describe the field of medicine (or any other biological discipline) as falling outside of the realm of science just because outcomes can’t be predicted with certainty, people often wrinkle their noses at the suggestion that trading and risk management be given the same designation. In my estimation, both are life sciences, driven by factors that lend themselves to prediction that falls short of certainty. Moreover, if we don’t accept that we can learn a great deal from certain patterns that tend to repeat themselves, in trading and risk management as in medicine and biology, then I would argue that we have no business whatsoever risking capital in the markets. From this perspective alone, unless you are committed to the use of available information inputs as the basis for a scientifically driven approach to portfolio management, there’s not much point in wasting your time with these materials. On the one hand, if you don’t see the opportunity—in fact, the need—to establish as clinical a trading environment as nature will allow, then your time will be wasted here. On the other hand, if you do choose to seek a statistical advantage through a sustained commitment to a rational and dynamic evaluation of both the market environment and the behavioral characteristics of your portfolio, then I’d say there’s cause for heady optimism. Your powers of intervention through observation-based decision making, should you be shrewd enough to use them, can open windows of profitability that are not only sustainable but also scalable.

The keys to success in the effort are, in my view:

1. Identification of a rational set of return objectives, combined with an unfettered commitment to adhere to the essential constraints that apply to your investment program.

2. Ability to estimate portfolio exposures, for the most part on the basis of simple, historical statistics.

3. Understanding of the tools available to adjust these exposures.

4. Capacity for identifying situations where exposure adjustments are necessary (i.e., when risk profiles don’t jibe with the aforementioned objectives and constraints).

5. Commitment to make such adjustments consistently and irrespective of the temptations that invariably exist to the contrary.

As we will see, risk management is much less about estimating and much more about doing—a subtle distinction that, sadly, is often overlooked by professional risk practitioners, as well as by those whose portfolios they impact.

The risk management investment takes several forms: These will include time, effort, and maybe some outlays for systems if your portfolio is sufficiently complex as to require the application of mathematical models to understand the pricing dynamics of instruments that you are trading. Most important, adherence to a sound risk management doctrine will routinely compel you to make trades and to assume portfolio profiles other than those that would precisely apply if risk management were not a consideration. Specifically, if you act as you ought, you will oftentimes find yourself unable to put as much capital at risk as you might like when great trading/investment opportunities present themselves. Similarly (though perhaps not as often), it may make sense to apply an excessive amount of capital at a trade about which you are less than thrilled—again, in the name of risk management.

The outlays imposed on those who choose to practice sound risk management therefore take the form of direct expenditures and opportunity costs. It should not surprise you that I will be encouraging you to view these “sacrifices” as investments rather than as expenses, for reasons that are implied in the title of this chapter and that comprise the core premise of this exercise.

Many of these concepts were well established long before that fateful day when I ventured into the field of risk management; but at least from where I stand, the process of applying them cohesively to the practice of portfolio management has been painfully slow to take hold. Most of my work over the years has thus involved the application of simple statistical principals to a practical risk-taking setting. Throughout the evolution of these efforts, I have attempted, at least nominally, to apply the scientific method (OGHET—Observe, Generalize, Hypothesize, Experiment, Theorize—to those who remember their school days) and would summarize the conclusions that I have drawn in the process in the following manner:

• There is a bona fide science that underlies the activities of trading, investment, and portfolio management.

• The various components of this science can be isolated and evaluated in terms of their impact on financial performance.

• Using an extremely simple set of statistical and arithmetic tools, it is possible to evaluate which elements of a given portfolio management process are working efficiently and which are not.

• In turn, by making these quantitative comparisons across periods of time and intervals of varying success, it is possible to gain insights into the specific elements of the process that are underperforming in periods of performance difficulty versus those that are working when things are going right.

• Although it is not always possible to correct problems without generating other inefficiencies in the portfolio management process, it is extremely useful to understand these undercurrents, such that traders can harness their strengths and minimize their weaknesses in the most effective manner available.

• The methodology is also very useful in determining which types of market conditions work most directly in portfolio managers’ favor and which work against them. In turn, this knowledge offers the opportunity to more efficiently match resource allocation to associated opportunity in the marketplace.

• When and where a portfolio manager finds areas for potential improvement, the same simple set of statistical tools that is useful in identifying problem areas can also be applied to attack the problems in a controlled manner.

This book and the risk management strategy I will outline simply build on these themes. We begin by discussing a process of identifying and living by a set of core objectives that will serve as the macrolevel measuring sticks of your success and/or failure. Here, you need to think very carefully about your options because, as I will argue when we get to it, there are multiple core objectives that rational investors can set for themselves, each based on a combination of market and personal factors and each implying a slightly different approach to portfolio management.

Once we have established the applicable objectives for performance analysis, we begin to build the statistical tool kit, which is designed to describe your trading portfolio from a quantitative perspective. The first element of this is what is commonly referred to as profit/loss (P/L) time series analysis, through which we will put your profitability patterns across time under a microscope—much in the same way that you would look at the technical patterns on the chart of your favorite security. Note that in order to achieve a practical understanding of time series analysis, it is necessary to grasp a small number of bedrock statistical concepts, most notably mean, standard deviation, and correlation. Each, in my opinion, is conceptually simple and easy to calculate. Taken individually and as a group, they can offer insights into everything from the way markets behave to the relative merits of trading strategies that hope to capitalize on this market behavior.

It is likely that you will have encountered these concepts elsewhere, perhaps in your academic training; and I believe they are useful tools for anyone wishing to better understand portfolio management and its various subcomponents. I encourage you, if necessary, to review your understanding of them, as they are easy to master; and very little else in the bothersome area of statistics is needed to perform the type of targeted performance measurement that is the centerpiece of this book.

Through P/L time series analysis, we will discuss ways to measure your returns not just in terms of dollars invested, but also as a function of the amount of risk you are taking. We will also explore a methodology for setting your exposures to levels that will allow you to reach your objectives, while at the same time enabling you to ensure that under most market conditions you do not lose more than the amount you have predetermined to be your maximum threshold for economic reversal. Separately, I will cover the topic of correlation analysis, focusing on ways to measure and interpret the implications of similarities between your performance and external factors, such as the performance of the market as a whole, as well as internal factors, such as how actively you are trading, how much you are investing, and so on.

With the P/L time series tool kit available to help you identify and evaluate your performance in a much more scientific manner, I then describe a range of alternatives at your disposal that allow you to modify some pattern you have determined is counterproductive to your overall portfolio objectives (or making inefficient use of scarce portfolio management resources, such as risk capital). In addition, I discuss ways to use the same tool kit that identifies problem areas to evaluate the effectiveness of any corrective action you choose to take. Again, these methodologies won’t be of any help in determining what trades to do when you are somehow operating outside zones of effectiveness. Instead, they will give you the means to identify and evaluate your alternatives in such a way that, I believe, best suits the very personal nature of the portfolio management process.

The final pieces of the statistical methodology I present are those that characterize your performance not across time but on an individual transaction level. By simply aggregating information that you have stored on individual transactions, you can do everything from figuring out how often you are right on a trade versus how often you are wrong, to determining how long you are holding each position and how this impacts profitability. Beyond this, I cover such topics as identifying and analyzing performance in individual securities, in sectors or market segments, in sides of the market (long versus short), and in amount of capital deployed in individual trades.

Trust me on this one—there’s a treasure trove of useful information here. What is more (and you’ll find me annoyingly repetitive on this topic), by frequently performing these same statistical reviews—across different time intervals and periods of varying performance—you stand to achieve a much clearer understanding of the impact of external factors (e.g., the market environment) and internal considerations (e.g., the individual compo...

Table of contents

• Title Page
• Dedication
• Copyright Page
• Preface
• Acknowledgments
• CHAPTER 1 - The Risk Management Investment
• CHAPTER 2 - Setting Performance Objectives
• CHAPTER 3 - Understanding the Profit/Loss Patterns over Time
• CHAPTER 4 - The Risk Components of an Individual Portfolio
• CHAPTER 5 - Setting Appropriate Exposure Levels (Rule 1)
• CHAPTER 6 - Adjusting Portfolio Exposure (Rule 2)
• CHAPTER 7 - The Risk Components of an Individual Trade
• CHAPTER 8 - Bringin’ It on Home
• APPENDIX - Optimal f and Risk of Ruin
• Index