Monday, 30 January 2017

Risk Control Rectangle

In this article, I would like to talk about risk management over the course of trading. Amateur investors tend to put most of their attention on how to invest to maximise their profits. There is nothing wrong about this, the point of investment is to make profit after all. However professional investors will consider seriously about risk management before the investment and during the investment.

What is the top priority of investment? To make money! One would naturally say. The truth is that the top priority of investment is to protect most of your capital intact during your investment process. The result of investment can only be two: profit or loss. You just need to be sure when loss happen, you don’t lose all or most of your money, such that you can still have the capital to continue to invest and hopefully make profit at the end. This is what a risk management system does.

If we consider investment as a battle, and chasing for profit is the offence aspect of a battle, then risk management is the defence aspect of the battle. If we fight long term battles, a pure offensive strategy will not last us very long while a good mix of offence and defence will keep us going and wining.

There are two risk controls in risk management
  • Credit risk control
  • Profit/Loss control

Credit risk control

Credit risk control is about choosing how much from your money pool to invest. It is the risk control before the investment.

There is a saying about stock market investment: “10% of investors making money, 20% of investors just breaking even, and the remaining 70% of investors losing money”. I am not sure whether this figure is accurate but I guess over 50% of the investors losing money in stock market probably not an under estimation. Here comes the question, why is that?

Before jump into conclusion, let me take an example. Say Joe has $1000 to invest, and he invests into a stock that has 50% of going up and 50% of going down. Joe is not a total amateur investor and he has strict win/loss control. Whenever the stock goes up 20% or goes down 20%, he will close the position and stop win/loss. And he chooses to only invest twice.

Then Joe wasn’t extremely luck and didn’t win on both investments, and he wasn’t extremely unlucky and didn’t lose on both investments. He ended up one won and one lost. With that, there are two possibilities:
  1. Joe won on the first, and lost on the second. His capital after first investment = 1000 + 1000 x 20% = 1200; His capital after second investment = 1200 – 1000 x 20% = 1000
  2. Joe lost on the first, and won on the second. His capital after first investment = 1000 - 1000 x 20% = 800; His capital after second investment = 800 + 800 * 20% = 960
What is happening there in scenario 2)? He won and lost exactly once, we would expect the capital is back to 1000 but why it is not? This is because after the first lost, Joe’s capital is down to 800, even he won 20% in the second investment, it's the 20% of 800 gain versus 20% of 1000 lost in the first investment.

The lost hurt more than the cure of won. This is always true in the investment world and some serious lost can make investor forever lost the opportunity of seeing the future win. This is where credit control comes in. You should always control how much you invest, do not dump all your cash in one go. In Joe’s example, if he had chosen to invest only $800 and not all his $1000 cash, he would have ended up even after a lost and a win.

Credit risk control is to calculate the potential risk of loss and choose a reasonable proportion of your cash out from your capital to invest to avoid run into credit risk.

Profit/Loss control

Nowadays, most of people know or have heard about stop loss or loss control. This is when you have picked a wrong investment; you decide to take a reasonable loss to exit and avoid possible greater future loss. The concept is straight forward.

Why do we need to control the profit? Isn’t that the bigger the better? Well the reason behind it is similar to why we need to control loss:

  • We predict the price will go down when we have a long position or the price will go up if we have a short position
  • Through historical data study we learn that the stock has reach the peak and most likely will go the other way
  • We need to lock in our profit.
As part of profit/risk control, we also have the time control. This is best to illustrate in the following diagram, which I call it the Risk Control Rectangle.

The following graph is a FX price chart taken for USDJPY. I have put a rectangle on a segment of the chart. As you can see each edge of the rectangle is drawn with different colors. I will explain the meaning of each edge and how they work together to form a strict risk control frame. For the purpose of easier to explain, I will assume we take long position in this example.



Blue edge – This is when we get into a position. The intersection of blue edge and the price line is the position price. When a position is taken, we have invested into something, opening up the opportunity of profit, as well as loss.

Red edge – This is where the stop loss control is. When the market price drops below this line, we will need to exit the position and cut loss. Depending on our trading strategy, this line can be fixed or can be dynamically changed over time, e.g. trailing stop loss control.

Green edge – This is where stop win control is. When stock price has gone up this line, we exit our position and lock down the profit. Again subject to trading strategy, this line can be fixed or can be dynamically changed over time.

Black edge – This when we consider our invest period is end and when we need to exit the position just because time runs out. The end time control is especially important for day trading strategy – at least we need to exit all positions before the market closed for day. It also makes sense for quantitative trading. If our strategy is based on x period of data, then our position held should be shorten then x period. Why is that? Quantitative trading is a game of predict the future based on the pass. It wouldn’t make sense if you study 3 days data and try to predict what will happen over 4 days, would it?

Conclusion

Through the risk control rectangle, we firmly control our profit/loss within a price range and time series range. Although the risk control rectangle itself doesn’t guarantee us the profit, it does protect our capital from serious loss in a single investment. This is extremely important for automated trading strategy since you won’t have a trader to watch the market for you.

1 comment:

  1. This control over market is necessary to bring the latest market trends in the market.

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