Trading Risk E-Book

Kenneth L. Grant

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 568

Veröffentlichungsjahr: 2011

Beschreibung

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.

Leseprobe

Table of Contents

Title Page

Dedication

Copyright Page

Preface

Acknowledgments

CHAPTER 1 - The Risk Management Investment

CHAPTER 2 - Setting Performance Objectives

OPTIMAL TARGET RETURN

NOMINAL TARGET RETURN

STOP-OUT LEVEL

THE BEACH

CHAPTER 3 - Understanding the Profit/Loss Patterns over Time

AND NOW TO STATISTICS, BUT FIRST A WORD (OR MORE) ABOUT TIME SERIES CONSTRUCTION

STATISTICS

PUTTING IT ALL TOGETHER

CHAPTER 4 - The Risk Components of an Individual Portfolio

HISTORICAL VOLATILITY

OPTIONS IMPLIED VOLATILITY

CORRELATION

VALUE AT RISK (VaR)

SCENARIO ANALYSIS

TECHNICAL ANALYSIS

CHAPTER 5 - Setting Appropriate Exposure Levels (Rule 1)

DETERMINING THE APPROPRIATE RANGES OF EXPOSURE

DRAWDOWNS AND NETTING RISK

ASYMMETRIC PAYOFF FUNCTION

CHAPTER 6 - Adjusting Portfolio Exposure (Rule 2)

SIZE OF INDIVIDUAL POSITIONS

DIRECTIONAL BIAS

POSITION LEVEL VOLATILITY

TIME HORIZON

DIVERSIFICATION

LEVERAGE

OPTIONALITY

Nonlinear Pricing Dynamics

Relationship between Strike Price and Underlying Price (Moneyness)

Implied Volatility

Asymmetric Payoff Functions

Leverage Characteristics

SUMMARY

CHAPTER 7 - The Risk Components of an Individual Trade

YOUR TRANSACTION PERFORMANCE

CORE TRANSACTIONS-LEVEL STATISTICS

CORRELATION ANALYSIS

PERFORMANCE SUCCESS METRICS

METHODS FOR IMPROVING PERFORMANCE RATIOS

PUTTING IT ALL TOGETHER

CHAPTER 8 - Bringin’ It on Home

MAKE A PLAN AND STICK TO IT

IF THE PLAN’S NOT WORKING, CHANGE THE PLAN

SEEK TO TRADE WITH AN “EDGE”

PLAY YOUR P/L

AVOID SURPRISES—ESPECIALLY TO YOURSELF

SEEK TO MAXIMIZE YOUR PERFORMANCE AT THE MARGIN

SEEK NONMONETARY BENEFITS

APPLY LIBERAL DOSES OF HUMILITY AND HUMOR

BE HEALTHY/CULTIVATE OTHER INTERESTS

APPENDIX - Optimal f and Risk of Ruin

Index

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The Wiley Trading series features books by traders who have survived the market’s ever-changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional, or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.

For a list of available titles, visit our web site at www.WileyFinance.com.

To Nina, for how could I possibly name anyone else?

Copyright © 2004 by Kenneth L. Grant. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

Chapter 2 opening lyrics from Shawn Phillips, “Spaceman,” COLLABORATION, © 1971, Dick James Music, Inc., & BMI. .

Chapter 6 opening lyrics from Paul Heaton and David Rotheray, Beautiful South, “LIAR’S BAR,” from BLUE IS THE COLOR, © October 1996, Universal Music.

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ISBN 0-471-65091-9

Preface

Make voyages. Attempt them. There’s nothing else.

—Tennessee WilliamsCamino Real

You are interested in making money in the markets, or you would not have selected this book from the millions of other choices—from, say, Thomas Wolfe to Tom Wolfe. If you’re going to forsake the sublime in favor of the pedestrian, then certainly you expect to be paid for the sacrifice. And who am I to blame you? The truth is, I’d like to get paid, too.

I’m here to tell you that our common objective demands more of us than simply making the right trades. Every single successful trader I know employs effective risk management as a part of his or her working program. Of course, I am biased on this subject because risk management is my career—a profession that has rendered me neither fabulously wealthy nor immensely popular with my colleagues, but at least perpetually employed.

Not that I set out with any direct intention to become a risk manager. In fact, it would be more accurate to say that I simply stumbled into it. Prior to this watershed event, I would have best described myself as someone loitering at the intersection between the financial and the academic worlds, looking for something to at least partially cover, if not justify, the financial toll visited on my parents as the result of their willingness to subsidize my two master’s degrees. Then, perhaps by fate, the futures markets beckoned. My uncle and his partners were looking for quantitative methodologies to estimate what they might lose if things went awry among the team of traders whose Chicago Board of Trade bond pit activity they were staking. This was back in the mid-1980s, when no one spent much time thinking about risk management and, therefore, no one I spoke to had much of a clue as to how I should begin this task.

I managed to muddle through, however, and did it well enough to convince the Chicago Mercantile Exchange (the Merc) to entrust me with the responsibility of building a risk management practice within the bowels of its clearinghouse: the central risk-processing unit for that vast and complex market mechanism. By this time, the field of risk management had evolved to the point that when I told people that this was what I did for a living, the comment was occasionally received with something other than a blank stare. We spent a good amount of time and resources thinking, talking, and engaging in much hand wringing on risk management—and ultimately to good effect, I think. What is more, the stakes were high. Given the impact of the 1987 crash on the Merc’s financial system, it was pretty clear that in the future it would have to have a pretty good handle on who was risking what in its markets, and with what resources behind them. Still, I won’t lie: There was much trial and error and many mistakes made before we ever began to get it right.

Since that time, I have more or less made a career out of convincing others that if risk management was their objective, I was their guy. My first such “patient” was Société Générale, the venerable French bank, where I gained the enormous advantage of applying the discipline to a multiproduct, multicurrency environment. This was certainly interesting and challenging, for a while; but cursed wanderlust eventually overtook me again. Only this time, I really fixed things for myself, landing in what can only be described as the Dodge City of risk management jurisdictions—the hedge fund industry. Here, as elsewhere, when I arrived, there were nearly no rules; so I had to make up my own. Now the place is a bit more civilized; but what is perhaps even more surprising is that the topic of hedge fund risk management has held my attention for the better part of a decade. Part of the reason for this is that I’ve had the honor to manage risk for some of the world’s finest traders, including Steve Cohen and Paul Tudor Jones, and have managed to survive such wide-ranging crises as the emerging markets meltdown of 1997, the collapse of Long-Term Capital Management (everyone’s favorite hedge fund till the winds blew ill there), the September 11 attacks, the fraud-related collapse of Enron and WorldCom, and a host of others too pedestrian to name in this space.

Along the way, it is good that I’ve learned what I think are some valuable lessons. And what’s even better (at least from an expository perspective) is that these lessons are remarkably consistent with one another and draw from a surprisingly small set of themes—themes that will form the framework for the core arguments I will put forward in this book. And while it would be silly to reveal all of them in the preface, I can at least begin to make the case as to why I believe so strongly in these materials.

As alluded to earlier, wherever I’ve gone in the world of risk management, from trading pits to hedge funds to banks, I have noted that the best traders and investors (and I’ve worked with both the best and the worst) are all, first and foremost, great managers of portfolio risk. I believe that this is more than mere coincidence, that, in fact, there is a positively Darwinian dynamic at play here. Making money in the markets is very difficult. No one does it all the time. Because great traders are seldom out of the market for extended periods, it follows that when they are not making money, they are actually losing it. Success, therefore, demands that they control their downside during periods of suboptimal performance.

I hope to convince you that my experience is not an isolated phenomenon and that risk management is not only useful but, in fact, essential. Even if you have the market insights and instincts of George Soros or Warren Buffett, your fate as an investor may very well ride on your ability and willingness to practice sound risk management. To be successful in the markets means having a clear understanding of the risks that are inherent in trading/investing profiles so as not to be surprised when bad things happen (and they will). Armed with this understanding, as I’ve been telling people for years, it becomes possible to actually control these exposures—at least most of the time, which, in my estimation, is a whole lot better than never.

The hard fact is that most people underestimate the control they wield over their exposure profiles, and this, sadly, applies pretty uniformly among amateurs and professionals. I can’t tell you how many times I’ve heard seasoned professionals express surprise at having lost $X in the markets, even though the likelihood of their losing $X was entirely foreseeable. Then they’ll go out and lose $X again (or $2X, or $nX, or even $Xn) and be surprised yet again, until the entire cycle degenerates into madness and insolvency.

Whether you are an individual trader or an investor who lost a bundle on the tech bust or a professional who bought the debt of one of the highprofile companies (e.g., Enron or WorldCom) that went belly-up as a result of the fraudulent activities of corporate insiders, it is entirely likely that you believe your misfortune was due to an ill wind—a virtual hurricane, a perfect storm—over which you had no control and couldn’t possibly have seen coming. In my experience, this is seldom an accurate characterization of matters. More often than not, when looking back on a difficult period in the markets, you will see that (1) there was a wealth of information available to estimate potential loss, and (2) this information could have been used to size exposures in a way that would have rendered even the worst-case scenarios entirely manageable.

Thus, we are not typically the victims of “Mother Nature” or other unseen forces; rather, we are often our own greatest oppressors. My business is to study market patterns to measure their attendant impact on portfolio exposures. And I can tell you for sure that, regardless of your place in the market pecking order, if you spend five minutes a week looking at simple statistics available online from any e-broker or professional data service (such as Bloomberg), you afford yourself the opportunity to gain a very clear understanding of the type of losses you are likely to incur when the markets take a turn against you. It is then in your power to adjust the risk downward if you don’t like the digits that such a review produces.

Of course, adopting this sort of approach isn’t necessarily conducive to the maximization of returns during periods of peak market opportunity. Quite to the contrary; it is designed to reign investors in at points when their enthusiasm might otherwise reach an apex. It may even cause you to curse your fates when it seems as though everyone else is riding a gravy train that left you at the station. But if you make capital preservation one of your main objectives and institute a simple program to achieve this outcome, not only will you not lose in the (not even very) long run, but you will see sustained and consistent enhancement of your overall financial well-being. Capital preservation during difficult periods pays off in the form of having the ability to put more capital at risk when trends become more favorable. Risk management is not just about not losing money; it is about preserving your capital in a way that will increase profits over the course of your investment career.

This book, then, will show you how to implement a risk management program and how to stick to it. I promise that you won’t regret it. The idea will be to create a system that will protect your capital and grow your returns. We will not be focusing on what markets you should trade or which specific financial instruments you should use or what trades you should put on once you have made these decisions for yourself. In these areas, you’re pretty much on your own. Our work together will largely be confined to creating a tool kit that will help you understand the statistical characteristics of your portfolio and to defining ways to use these statistics to effect portfolio decision making that is consistent with your financial objectives and associated constraints.

You can think of this book as a practical guide to the art and science of risk management. I hope that once we’re through, you’ll agree with me that this is a unique perspective on this topic, primarily because of its direct focus on how to actually devise and execute a risk management strategy for your portfolio. It’s not that we will ignore entirely the concept of risk estimation, which, near as I can tell, is the all-encompassing obsession of the risk management literature published thus far. No, we won’t forsake these mysteries; rather, we will reduce them to the simplest mathematical forms possible, such that they are both understandable and applicable to the practical situations you will face as a portfolio manager. Perhaps more important, we will use risk estimation merely as the starting point for our risk management program, rather than as an end in itself. We will focus most of our time on discussing how to use these and other tools to deal effectively with such real-life portfolio management problems as

• Determining the levels of exposure most consistent with our objectives, in light of our constraints.

• Identifying alternatives for risk adjustment whenever exposures fall outside of these ranges.

• Anticipating and correcting for internal and external factors that create incentives for portfolio managers to take action that works against their interest from a risk management and capital preservation perspective.

Trust me, brothers and sisters, your success in risk management (and, I would argue, in portfolio management as a whole) turns much more on these matters than it does on selecting the right betas for your stock portfolio or the appropriate model for pricing your options. I have learned this the hard way, in extraordinarily aggressive risk-taking environments, across as diverse a set of market conditions as anyone could reasonably expect to experience over an entire career. I feel that these experiences are both unique and instructive and that they have given me insights worth sharing.

So I’m excited about the prospects for success in this little joint venture of ours, and I hope you are, too. If it works, you’ll come away from the experience with a handful of simple guidelines that will save you a fortune in times of duress and, as a result (so I would argue), make you a fortune over the course of your investing career. Along the way, I’ll share some of my goofier experiences and give you some insight into rock and roll—a topic on which I have even more to say than I do about risk management. But rest assured that throughout, we’ll keep our eyes on the prize: establishing a simple, workable risk management program that is consistent with your objectives and that allocates your scarce, risk-taking resources efficiently across the full range of triumphant and tragic conditions you will experience as an investor.

What do you say? Let’s get started.

KENNETH L. GRANT

New York, New YorkJuly 2004

Acknowledgments

This book, nearly five years in the making, draws both directly and indirectly on my experiences in risk management over the past couple of decades. As such, I want to express my heartfelt appreciation to everyone I worked with over this time period, for all of their instruction and for a million smiles (and a few tears). I am particularly indebted to several of my bosses and closest colleagues, among them my uncle Ron Manaster (who gave me my start in the business); John Davidson, Kate Meyer, and Phupinder Gill (my bosses and colleagues at the Chicago Mercantile Exchange, who gave me my first big break); Pierre Schroeder (my supervisor at Société Générale, and one of the most outstanding professionals I ever encountered); Dr. Ari Kiev (who planted the writing seed in my brain); John Macfarlane (my manager at Tudor, who helped me really frame much of the philosophy embedded in this book); and, of course, the illustrious chairmen and senior management of SAC Capital and Tudor Investments. In addition, I gratefully acknowledge specific assistance on this project from individuals including John Higgins, David Hwang, Chris Meier, and others, who know who they are but whom, for various reasons, I won’t name specifically. Each lent a significant hand to the process at critical stages; and, had they not been there to provide a helping hand, I believe it would not be an exaggeration to say that the book might not have been completed. I’d also like to thank my editor, Pamela van Giessen, who hung in there over the past half decade through many fits and starts and whose patience and guidance were a driving force in bringing these materials into publication.

Finally, and at the risk of descending beyond the point of utter sentimentality, I want to thank my wife, Deanna, and my children, Brianna and Alex, for making the journey a joyous and worthwhile one and for forcing me from time to time to be at my best, whether I wanted to be or not.

Sincere apologies (and thanks) to anyone I’ve forgotten. My memory is not what it used to be.

K. L. G.

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 components of your decision making) on your prospects for achieving your goals and living within your constraints. In turn, the routine performance of statistical analysis across periods of relative success will allow you, should you so choose (and I think you should), to match up your market activity with the conditions and the modes of operation that are most conducive to your success. This alone won’t ensure glory or even consistent profitability, but it will give you a heck of an edge over your peers and other market participants who don’t heed these metrics and, as a result, risk squandering at least a portion of their scarce investment resources in ways that are almost certainly counterproductive—given their goals and constraints.

We don’t want to overstate the case here. While the analytical approach I will recommend ought to be useful to just about everybody, it is wrong to think that it offers a precise road map for improved performance. In my experience, there are very few unambiguous diagnoses and even fewer unilaterally beneficial remedies that emanate from the regimens prescribed in these pages. In fact (as we will discuss in detail later), there is a significant risk of taking too literal an interpretation of the analytical output and reacting to it in ways that will actually impede your path to optimal performance. For example, the numbers may indicate very clearly that the longer you hold on to individual positions, the better the result. However, if you respond to this input by simply lengthening your holding periods on every trade you do, taking little or no heed as to how this adjustment might impact other elements of your portfolio decision-making process, it’s a fair bet not only that will you not experience improvement, but also that you will lose in terms of both money and aggravation. It pains me to offer this disclaimer, but in the name of public service, I believe I am obliged to do so. Put it this way: If I had discovered any reliable statistical methodology that offered simple, unambiguous remedies for the scourge of portfolio management underperformance, (1) I’d be even more fabulously wealthy than I already am, and (2) I’d need to have my head examined if I even considered the possibility of sharing these results in written form for the royalty on the price of a book.

Know instead that the secrets to deriving full benefit from this magic can be found in the subtler shades of your market experience. These secrets take the form of putting your capital to work when its prospects for yielding some benefit are high; of avoiding the repetition of identifiable mistakes; and of relying on those formidable but elusive twin pillars of the temple of gracious living, patience and discipline, when the likely short-term benefits for such reliance are neither comfortable nor gratifying.

“To thine own self be true,” said Polonius to Laertes, in Shakespeare’s Hamlet; and even though both were ultimately dispatched by the capricious blade of the Mad Dane, I think this advice was worthy of a loving father to his son. Brutal internal honesty is about as adaptive a trait for market participants as I can think of; and, for reasons that should be clear by now, honesty will be a major theme of this document. With this in mind, and before we start with the gory but necessary details of portfolio analysis, I’d like to share some high-level qualitative observations that I believe are perfectly in keeping with the spirit of both what I’ve written thus far and what those steadfast enough to forge ahead will read in subsequent chapters:

Have a Plan and Stick to It. Prior to engaging in market activity, it is important to take a careful study of everything from your objectives, to the resources you have at your disposal, to the market inefficiencies you are trying to exploit. Unfortunately, my experience in these matters is that even among professional money managers, this type of planning is the exception rather than the norm.

Fight for Every Fraction of a Point in Trade Execution. Oftentimes, even the best portfolio managers are focused more on the quality of their trading ideas than on the execution of the strategies. This is a critical mistake. Great ideas are easy to squander, and great follow-through always pays off. By carefully engineering your points of initiation and liquidation, you will experience significant positive differentiation of revenues, relative to a strategy that doesn’t feature this level of diligence—no matter how great or lousy your ideas are.

Don’t Do a Trade Unless It Is Tied to a Predetermined Target Price and Stop. As part of the process of both position selection and executions management, you should always adhere to a prespecified price range, on both the upside and the downside, that serves as a prerequisite for keeping the position open. This means that if the market you are trading either reaches your target or violates your stop/loss level, you must liquidate the position. If you still feel you are correctly positioned in this particular instrument, then get out and reinitiate the position with new target/stop parameters. If you do this, you are shaping your own destiny on every trade. If you don’t, then there’s no limit to how much money you can theoretically lose on a given transaction. Sooner or later, some combination of trades will blow you up.

Don’t Operate outside Your Limits or Other Constraints. Whether you are trading for yourself or earning your keep managing other people’s money, you should have a series of limits in place that govern your portfolio management activities. These limits will invariably prevent you from constructing your ideal portfolio from time to time, so adhering to them will routinely imply trade-offs between what you feel is warranted based on market opportunity and what I argue is best for your long-term well-being as a portfolio manager. You will provide your own counsel in these instances, but I urge you to allow risk-control considerations to carry the day. Although you may be correct in your assessment of what’s going to happen in the markets at any given time, your risk parameters are based on more static considerations that are likely to be less influenced by wishful thinking (e.g., by personal financial constraints or by the risk-appetite constraints of external capital providers).

If you live within these parameters (assuming they are set rationally), you may give up some upside in selected situations, but you gain the considerable benefit of control. By contrast, if you violate them routinely, someday you are almost certainly going to be wrong, and in a big way (to paraphrase Blondie, “One way or another, it’s gonna getcha getcha getcha”). I have seen even the most highly regarded traders in the world end their careers rather meekly because of this unfortunate reality.

Compare and Contrast Periods of Relative Success. Among the most important methodologies for portfolio diagnosis that I will describe in this book is that of comparing individual portfolio decision-making elements in periods of strong success against those in intervals of frustration. For example, you may want to compare such factors as your correlations to market benchmarks, or trading winning percentages across these interludes of diverging fortune, in order to see if they are markedly different. As we will discuss in great detail, this won’t necessarily give you an answer key as to what will work in the future, but it will certainly offer insights that may help you apply your capital and other scarce resources more efficiently.

Try New Things. Markets, by their very nature, are in a constant state of flux. One reason for this is that any strategy yielding above-average risk-adjusted return (which we will define in painful detail later) is, by the unshakable laws of human nature, under a sustained threat by other market participants seeking to correct this “inefficiency.” Indeed, as any close observer will tell you, the rate of change is increasing at an increasing rate. This means that there is a limited shelf life for nearly any highly successful market approach. Ultimately, I believe that almost any strategy either will require significant tweaking or will be periodically subject to diminished returns over what constitutes a very real but little understood business cycle that exists for market participation of all kinds.

As a result, only those who are willing to perpetually adapt to change have the opportunity to succeed consistently at trading and investment over a lifetime. In addition to encouraging you to be proactive in the adaptation of your strategies, I will show you ways to use a statistical tool kit to establish a framework to ensure that your forays into uncharted waters are undertaken as controlled experiments, such that the likelihood of their success can be maximized, with minimal damage if things go wrong.

Take More Risk When You Are Up and Less When You Are Down. The Children of Israel didn’t receive this commandment from Moses on the mountaintop, but I’m pretty sure that it was in the first draft of the tablets. Rumor has it that the Almighty, in his infinite wisdom, removed it as part of the punishment for that idol-worshiping romp in the desert (as led by Edward G. Robinson in the Cecil B. DeMille vehicle). It thus falls upon mere mortals such as myself to lead the faithful out of the wilderness of setting risk levels that don’t include recent performance as a key decision factor.

The practice of sizing your risk on the basis of recent P/L performance is perhaps the most important rule for success that I’ve encountered in the markets. However, even if you buy into the concept, you will find it among the most difficult of conventions to follow (ranking, by some accounts, on a par with that one about thy neighbor’s wife). This is particularly true when you are losing money, as there is a natural urge to increase exposures during difficult periods in the hopes of minimizing the time period of underperformance. Your instincts will tell you to load up and make it all back as quickly as possible—and your instincts couldn’t be more wrong. For enlightened portfolio managers who wish to have long careers, the price of a P/L setback is measured not in the dollars needed to recover but in the time necessary to make those dollars.

By contrast, those who choose to increase their exposures after a difficult interval may see this strategy pay off once, twice, or even several times; but ultimately, it is a ticket to disaster where they will bomb out—perhaps in spectacular fashion. A mentor of mine, and one of the true pioneers of modern-day portfolio management (okay, it’s Paul Tudor Jones), is fond of saying that sooner or later, we all go to the trader graveyard. In my experience, this does not actually have to be the case. I believe that if you cut losses during periods of performance difficulty, you can, in fact, trade into a state of immortality.

In addition to arguing the merits of setting your exposures as a positive function of performance, I will discuss simple statistical tools that will enable you to operate at exposure levels that will help you to stay in the game indefinitely, no matter how badly you may suck at reading the markets.

HEY, JOE, WHERE ARE YOU GOING WITH THE RISK IN YOUR BOOK?

Listen, Joe, I need to speak to you about your portfolio. I’ve been watching you closely over the past few weeks (of course, as your risk manager, this is my job). I know your performance has been a bit disappointing, but I want you to know I’m not particularly troubled about that. You’ve been through this before, and I’m confident that you’ll pull through quite nicely, as you always have in the past. However, I do sense a certain anxiety on your part; and I won’t lie to you, this concerns me a great deal. I know it’s getting later in the year, and you’re anxious to reverse your performance so you can get paid. I also sense, and correct me if I’m wrong here, that you’re sniffing big opportunities in your space. Bottom line: My instincts tell me that you’re debating whether now wouldn’t be a perfect time to increase your risk profile.

What’s that? Did I hear you say you want to take a shot here? Of course, you do! After all, we’re looking at a world-class market opportunity, are we not? You’ve done your homework, and you couldn’t possibly be wrong, could you? Besides, you’re tired of losing money, and I don’t blame you one bit for this. To put it bluntly, your recent performance has sucked, and the only rational answer is to trade bigger. There’s certainly no portfolio management problem I’ve ever encountered that couldn’t be solved by simply trading in bigger sizes, and God Almighty didn’t breathe life into us just to trade for chump change. Once you’ve nailed your big trade, a lot of things are going to change for the better. You’ll be nicely profitable, and you’ll be in a great position to move forward in the markets in a very disciplined manner. All you really need to do is to get this next one right, and everything else will fall into place.

But what if you’re not right? Trust me here, you’ll have bigger problems than you are anticipating at the moment—so big, in fact, that I strongly suspect the upside is not worth the downside. For one thing, you’ll have lost a good deal of money—in the process further exhausting your risk capital at a most inopportune time. What’s more, it will be difficult, without great effort, to rationalize away the following unpleasant realities: (1) Your thoughts about what constitutes a high-conviction trading opportunity are somewhat less than infallible; and (2) you’ve failed pretty unambiguously at the challenge of capital preservation—at a point when capital preservation was a particularly important objective. At that point, your capital reserve and confidence will be at an ebb; and what might be worse, I will be looking more fervently over your shoulder than ever before.

You now have the opportunity to play your big idea in smaller size. If you do this, no matter what happens, you will experience a palatable range of outcomes. Assuming you nail the trade, you should still make money (just not as much as if you had played it in large size). If the markets go against you, the financial damage will be minimal. Either way, you will gain the confidence that emanates from a sound and consistently applied risk management program. All of this could be yours by simply setting aside some of your remaining capital for a rainy day (sort of like an investment, if you catch the drift) and sacrificing some potential upside on a single set of high-conviction market ideas. At the end of the day, you’ll probably end up ignoring my advice and, if things go wrong, just blaming the risk manager. Why not? Everyone else does. But for your own welfare, I urge you to take a good look in the mirror and ask yourself whether you might’ve had just the teeniest hand in creating your own misery from this sorry episode.

Always Save a Healthy Amount of Risk Capital for “Special Situations.” Although the act of playing your best ideas at smaller sizes during a period of suboptimal performance is a prime example of the Risk Management Investment at work, you may be surprised to read that it does not always represent the best use of your risk management resources. I must point out that the mark of portfolio managers who have truly mastered these concepts is their ability to nearly always have an abundant reserve of risk capital available for high-conviction market opportunities. Specifically, by practicing relentless risk management throughout all phases of a trading cycle, they avoid suffering precipitous drops in their risk-taking capacity and are therefore poised to take advantage of unique opportunities, whenever they present themselves. This means setting aside a portion of their profits on all of their winning trades, as opposed to always and immediately redeploying these winnings in the market. It means cutting losing trades before their impact extends beyond that of mere annoyance. It means being patient about recovering losses after a bad spell, and it means exercising restraint and discipline at all times. This is what great traders do.

By contrast, mediocre traders often find themselves on a treadmill, where they’ve repeatedly squandered their risk capital on substandard ideas—a problem that they frequently exacerbate by pressing their bets at the wrong time. Then, when really good ideas do formulate in their brains, they have neither the means to put the trades on in respectable size nor the staying power to hold the trades long enough for the sequence that they envision to play itself out. After the fact, they curse their luck and blame sinister outside forces for their inability to make any money, the accuracy of their predictions notwithstanding.

I’m here to tell you that there’s very little luck involved in these situations; that there are indeed outside forces at play; and that you are not wrong to believe there is a systemic conspiracy seeking to ensure that when your market prospects are at their greatest, your ability to capitalize on them is maximally constrained. This is true because portfolio managers as well as those who monitor their risk tend to operate with something of a herd mentality. Traders often have similar thoughts about market opportunity and routinely put on the same types of bets at similar times. In turn, risk managers (a breed not typically distinguished by their propensity for original thought) tend to impose similar types of constraints on portfolio managers, who therefore tend to effect risk reduction, at the same time and in a homogeneous fashion. Many, many times this means selling at or near the absolute lows or covering short positions at the top of their ranges. These risk-reducing trades often leave pricing inefficiencies in their wake, and those who have carefully preserved capital (i.e., those who are invested in risk management) frequently find themselves in an ideal position to capitalize. So when your risk management system tells you to sell your longs or cover your shorts, it is no accident that you may be making the former trades at the lows and the latter ones at the highs. And rest assured that the windfall you may be handing to the person sitting on the other side of the trade is likely the result of superior risk management on his or her part.

Examples of this “group-act” occur just about every day, embedded in market events both large and small. Consider the 1987 crash: Consensus was pretty bullish back then; and speaking for my fellow geezers everywhere who remember this event, the timing took everyone more or less by surprise. Anyone who was aggressively long got carried out; and for much of that day, there were no buyers anywhere (the New York Stock Exchange specialists showed themselves to be especially gallant by not answering phones and hiding under desks). So most who were forced to sell did so at or near the absolute lows. By contrast, some market participants were aggressively short, and they received a very fortunate windfall. Here’s hoping they put some of that away for a rainy day.

Others—those who managed its risk very carefully, trading both sides of the market and maintaining a healthy reserve of risk capital for all contingencies—had a world-class opportunity when the market restabilized by staging an impressive four-month rally from its early December low. From there, as everyone knows, the markets were off to the races for more than the next decade. By carefully contrasting the outcomes that befell the heathens with those of the risk management faithful, one notices an acute dichotomy. With regard to the former, not only did they probably lose their shirts during the crash, but they also missed a chance to load up early into a market that increased fivefold over the next decade. By contrast, those who minimized their damage in 1987 had investing power aplenty to catch the wave.

There are a whole bunch of scenarios like this, playing themselves out in events dramatic and mundane. Success can be defined in terms of having the capital to risk when risk is worth taking, or at least of having the sense not to take big risks when you can’t afford to be wrong.

Make Sure You’re Taking Enough Risk to Justify Your Trading. There are also situations when the Risk Management Investment actually dictates the need to assume higher levels of exposures than those you are predisposed to take. And while these are perhaps less intuitive, the impact is often no less dramatic and, as such, they bear mention. One such situation occurs when the portfolio manager is operating at levels of exposure so low he or she can’t possibly hope to meet return objectives. This manager may believe that he or she is being prudent, but I would quarrel with this characterization—particularly for professional money managers, a group who in my experience quite often run into this problem. You are not going to endear yourself to your capital providers by using up their financial and perhaps trading infrastructure resources in efforts that can’t hope to produce the desired level of performance. For many of those to whom this applies, their risk-taking deficiency may render it impossible for them to even cover associated infrastructure costs. And I have witnessed enough of these scenarios to know with certainty that this is a condition that cannot last for long. Either risk taking increases, or the individual in question gets fired. It’s as simple as that.