"Risk Management"

The main difference between an amateur and a professional trader is that the professional always tries to understand and control portfolio risks. Before entering into any trade, you should first think about how much risk to take and how much risk exposure comes with a particular trade selection. Only then should you consider how much profit you stand to make. Prudent investors always cut down their position and exposure if they determine that a portfolio carries too much risk. They calculate this all-important estimation by employing Risk Management: that set of methods and procedures taken to estimate, quantify, and control risk for the purpose of achieving optimal investment results.

Performance Benchmark, Beta, Correlation, Volatility and Return/Risk Ratio

If an investor bought a stock at $100 and sold it six months later at $116, then he would realize a profit of $16. His annualized return would be 32%. No doubt, this is a good investment result. But is this a better or worse investment compared with others? Without some form of systematic analysis, we cannot tell: to properly evaluate investment performance, we need to consider the return, the risks involved, and how the outcome compares with other possible investments. Usually, the Standard & Poor's 500 index is used as a performance benchmark, for it is a good representation of the entire US equity market. By this measure, an investment is considered good if it outperforms the benchmark on a risk-adjusted basis.

In order to quantify risks and measure risk-adjusted performance, financial analysts apply the concepts and measurements of market beta, correlation, volatility, and return/risk ratio.

Beta

Beta is defined as the linear regression slope of a stock portfolio (or a single stock), the benchmark over a specified period of time. For example, one can compute the beta of IBM stock with respect to the S&P 500 index over the past six months. One first calculates the time series of the daily percent change of IBM stock prices and the daily percent change of the S&P 500 index; then, one computes the linear regression slope of the two time series. This serves as the measure of a portfolio's risk relative to the market; the meaning is straightforward: on average, if the index moves 1 percent, then the stock moves Beta percent.

Correlation

Correlation is defined as the linear regression correlation coefficient of a stock portfolio (or a single stock) and the performance benchmark over a certain period of time. For example, one can compute the correlation of IBM stock with respect to the S&P 500 index over the past six months by first calculating the time series of the daily percent change of IBM stock prices and the daily percent change of the S&P 500 index. Then, one computes the linear regression correlation coefficient of the two time series. The meaning of this complicated idea can be simply put: if the index moves up, correlation percent of the time the stock also moves up.

Volatility

The volatility of a stock (or of a stock portfolio) is defined as the standard deviation of daily percent changes of the stock (portfolio) price. For trading, daily volatility is a very useful measure of risk: percent of the time, stock price moves up or down percent in a day. It is important to know the difference between this daily volatility and the annualized volatility, which is used in stock-option and derivatives valuation.

Zero-Risk Investment is like a bank account that earns risk-free interest, while at the other extreme, some individual stocks are extremely risky, leading to a great variation in the range of potential return or loss. In examining many different kinds of investments over long periods of time (like ten years), a graphic representation would appear like a cloud with a rather clear upper boundary. This boundary is called the Efficient Market Frontier. If an investment lies on the efficient frontier, it is considered optimal or advantageous. According to academic theory, it is not possible to make fruitful investments on stock that plots consistently above the frontier. In other words, as a consistent strategy, one must take more risk in order to obtain higher return.

VAR (Value At Risk)

Another Risk Management concept is called Value At Risk. Many investment and trading businesses use Value At Risk as one of their main risk measures in routine risk management operations. Value At Risk is an absolute risk measure for your portfolio, in units of dollars per day. Many investment companies use the daily 95% confidence Value At Risk definition: this formulation assumes that in a given trading day, there is a 95% probability that the portfolio will not lose more than Value At Risk.

For example, if the Value At Risk is $800, then it is 95% certain that the portfolio will not lose more than $800 in one day.

Understanding the statistical meaning of Value At Risk is important: a small Value At Risk number does not guarantee that you will not lose more than Value At Risk; it only says that, with 95% probability you will not lose more than Value At Risk in ONE day.

The calculation of Value At Risk requires the study of the price time series of all the stocks in a portfolio. Value At Risk depends on many factors, such the volatility of each stock, the correlation among all the stocks, and the stability of their historical relationships.

Hedging

You often hears phrases like "hedging your bet", "hedge the trade," "hedge the position," "hedge my portfolio." Hedging simply means the specific risk management actions one takes to reduce or "neutralize" risks, for example, like the efforts one might take to protect a flower or vegetable garden by surrounding it with a hedge. Hedging entails three steps:

• Analyze your portfolio to identify and quantify risks and their sources.
• Add, remove, and adjust your holdings so that the risks are reduced or neutralized, in accordance with your chosen risk-management system.
• Execute the trades necessary to implement your new portfolio.

Sometimes hedging is as simple as selling the riskiest stocks in your portfolio, or adding a less-volatile stock to it.

Single Trade Risk Management

Single-trade risk management can be summarized by these fundamental principles:

• Know how much you are willing to lose before you execute trades.
• See if the stock is sufficiently liquid (active) should you wish to buy or sell promptly.
• Determine the cut-loss level before trading.
• Determine your profit target (take-profit-level).
• Buy the stock only at an acceptable price level. Use a limit order when you buy a stock.
• Immediately after the trade has been confirmed, enter the stop-loss-at- market order at your predetermined stop-loss level.
• If the trade starts to win significantly, raise the stop level so that your Winner Will Never Become a Loser.
• Take profit promptly as the trade reaches your profit target.

The risk management process has to begin before you begin a trade. Most important, you must know beforehand how much you are willing to lose, along with how much you can lose in a planned trade. For example, in buying a stock, one should first consider potential loss, study the stock by reading news briefs, use charts and other tools to analyze the stock, and decide if the stop-loss level is reasonable and acceptable. Only then can you properly determine the number of shares to buy. You should also check the liquidity of the stock, for if the stock does not provide liquidity enough to permit quick sale, you might not be able to close the trade as your risk management plan requires. Immediately after a trade is confirmed, enter the stop-loss-at- market order to control the risk. We've observed how often professional traders say, "Never Let a Winner Turn a Loser," a fundamental principle in risk management. As soon as the trade moves in your favor - say you've made a profit that is eight times the typical bid/ask spread of the stock - you should enter an adjusted stop-loss order to replace the original. That way, the trade will not be a loser if the stock turns back.

Portfolio Risk Management

If you actively manage the risk of each trade in your portfolio according to this single-trade risk management method, your whole-portfolio risk will be well under control. After all, a portfolio is just the aggregate of all your individual single trades. However, it is also important to manage your overall risk at the portfolio level. The following is a list of key points for managing portfolio risk:

• Know your overall risk tolerance before building up the portfolio.
• Determine your overall cut-loss level. Usually your portfolio should not lose more than 10% of your capital.
• Diversify your investment in at least three or more different stocks.
• Actively manage the risk of every individual trade.
• Know your overall risk and where the risk comes from.
• Act quickly when you see your risk management limits exceeded.
• Close out the entire portfolio if it loses to your overall stop-loss level.
• Stay in the game.

This last point, "Stay in the game," is most important in trading and investing. It means that cutting losses before they are too big enables one to remain active. By always recognizing risk limits in a trade by cutting losses when a stock is down 2%, then even if you lose ten times in a row, you still retain 80% of your capital and can remain in the trading game. As the experienced manager of a major Wall Street trading department once said,

"I saw people come and go. Most new traders lose money and leave. Some make very little money or lose small money in the first few years. Then they start to make more money as they survive on the trading floor. Your ability to make money grows exponentially if you can stay in the game."

The risk management strategies we've discussed provide the crucial means of surviving and growing in today's market by applying the same rational controls that keep long-experienced traders ahead!

Investing Versus Trading

Investing is a long-term process towards the achievement of your financial goals. Instead of buying and selling securities trying to time the market, you should remain focused on achieving a high long-term return while keeping volatility and risk, at low levels. Studies have shown that asset allocation contributes 80 to 90% of a portfolio's overall return whereas market timing and other speculative techniques can actually lower the return.