Thoughts on Risk Management

I would like to explain in very simple terms and easy to understand by pro and novice et al.

Step I:

1) Decide on Portfolio Allocation: Portfolio allocation starts with defining Financial Objectives : How much money you would need and when? Your assets, liabilities, income and expenditure. This is a different subject altogether but still ultimately one (even a trader) has to start here.

(a) Variable (positive / negative): Equity, Real estate, Gold, F&O (Directional positions)
(b) Variable (positive but unsteady returns) : F&O (multilegged strategies primarily using Options)
(c) Fixed (positive) : FDs, NSCs, PPF etc

2) Decide on time frame to adjust Protfolio Allocation : Could be quarterly, half yearly or yearly. Depending on your portfolio performance, income from other sources/job/inheritance etc

Step II: Here I am zeroing on the aggressive part of portfolio allocation - Trading in Options:


1) Risk = Uncertainty of DESIRED outcome
2) Desired Outcome = (a) + (b)
(a) Primary Desired Outcome = For position taken at Time T0, price CHANGES in favour of position taken at Time T1
(b) Secondary Desired Outcome = MAGNITUDE of price change from P0 (at Time T0) to P1 (at Time T1)

Hence at Time T0 and Price P0, we need to define both, T1 and P1.

For a one market, one instrument, one trading plan trader (like me) T1 is sacrosant (FIXED), P1 is the only variable.

P1 is defined before trade initiation. P1 is defined both for positive outcome and for negative outcome.

Eg If I am buying Nifty Options @ time Time T0 at price P0 (Rs. 100), and defined is P1 is Rs. 95 (worst drawdown) or Rs. 107 (best outcome), my Risk is Rs. 5. (Rs. 250 for one lot).

If my trading capital (which is PART of my Portfolio) is say 10 L and I decide to RISK 2% per trade (this % is decided at the end of each week for the next week depending on the performance in the week gone by. The range of Risk / trade is between 1% to 4%), then I would buy 80 lots of Nifty Options.

At time T1, the probable outcome of Option prices could be:

93 : Exit fully (2.8% loss of trading capital : 80 x 50 x (-7) = -28000)
95 : Exit fully (2% loss of trading capital : 80 x 50 x (-5) = -20000)
97 : Exit fully (1.2% loss of trading capital : 80 x 50 x (-3) = -12000)
100: Exit fully (0% loss of trading capital : 80 x 50 x 0 = 0)
103: Exit 75% (0.9% profit to trading capital : 60 x 50 x (+3) = +9000)
106: Exit 50% (1.2% profit to trading capital : 40 x 50 x (+6) = + 12000)
109: Exit 25% (0.9% profit to trading capital : 20 x 50 X (+9) = +9000)

You would notice that if the price at Time T1 is less than 100 I exit fully and on some occasions the loss could be higher then anticipated 2% in this case if I exit at 93. But this margin of error in my risk management is acceptable since I exit at Time T1.

Secondly you would notice that at price levels > 100 (i.e. 103, 106, 109) I have partially exited. But these exit % are NOT RANDOM.

If the price is > 100 at Time T1, then this T1 becomes new T0 and the current price say 103 become new P0. From here I would again calculate new P1 (both worst drawdown and best outcome scenario) and accordingly adjust the quantity.

Step III: Later today/tomorrow...:

Regards,

Step III:

Treat your profitable trade and non-profitable trades seperately. The MOMENT I close my profitable trade, the profit made on the trade flies off out of my trading capital account and rests in a different account which is my Variable - steady profit funding account, where I use multilegged Options strategy with low risk and average returns as the time frame used in these strategies is quite larger (almost 2 to 3 weeks or sometimes till near month expiry). Most common strategy is Covered Call, which may be covered in detail in some thread on this forum. Also sometimes, strangle or straddle or simply deep OTM call/put writing, depending on the market condition. HOWEVER here too, my RISK management techinique is quite similiar to the one mentioned in step II of trading naked options. i.e. P0 at T0 and defining P1 at T1. i.e. fundamentally though the strategy has changed as the funds are from different account, but RISK management is still the same.

Now as I keep withdrawing the profits from my trading capital account, and continue trading eventually my trading capital would tend to cease some point of time as there are some loss making trades which eats the trading capital. Yes this is what could happen eventually, hence with each passing period, my trade size reduces as my trading capital reduces. Though my Trading capital could tend to be zero it doesn't happen, WHY?

Because, remember adjustment in Portfolio Allocation (Step I), which I do every calendar quarter end. Hence basically I have to live with my trading capital for a period of 3 months, the better I trade I get more quantity to trade and then quantity decreases gradually. Profits keep going out.

When Portfolio Allocation adjustment happens at the quarter end, Trading Capital is top-uped up STRICLY on the basis of trading performance in the last quarter, hence if I started with 10 L trading capital which was reduced to 5L in three months and has generated profit of 8 L then I may be entitled to top up to 10 L or even higher depending on my overall Portfolio performance in the quarter gone by. Alternatively instead of 8 Lacs if the profit generated was 4 Lacs, then my trading capital can be top-uped to a max of 9 L it could be generally be lower viz, 8 L or 7 L as performance was NOT ACCEPTABLE.

STEP IV:
At the quarter end review and portfolio allocation adjustment, majority of the incremental profits generated by Trading, Variable (steady profit) strategy are allocated another account which funds conservative investment account. The investment made through this account essentially follow simple 100 days / 200 days moving averages which are held for longer period of time.

STEP V: The most important.will follow later today.

Regards,

Dear tnsn2345,
excellently expressing, objectively planned.........now lies execution study......close loop experience.
After step IV.......pl continue.......

Also prefer ur comment on execution study .
Kudos to u .
thanks once again

....................................................................
This marginal trade and oppurtunity trade r excellent money management concept........an advance level learner on market practices.......first one is how much more he can squeeze out of same trade.opportunity trade in mm is spill bean concept.........both r subjective.
By the way, similar name trade exists ........both r used by momentum traders.......a volume set up , then a trigger on price......a quick small profit execution.u can do it mathematically
Sorry as i worked as project coordinator.......i have to attend some critical call from site.

STEP V: THE PURPOSE!!!!!

Why do we do all this? i.e. trading, portfolio allocation, risk management etc. Do we want to grow our wealth to Eternity and leave it for someone after we are gone. NO.

I am working as a portfolio manager (or better still - a hedge fund manger) then I should be paid for my services. This is what precisely I do when I levy PMS charges every quarter end and take out that amount from the Portfolio to my 'personal account' for my personal consumption. The charges I levy are similar to any PMS charges which includes, fixed and performance linked payouts over a hurdle rate of return every quarter.

p.s. :

1) To maintain simplicity here I have not covered Portfolio performance parameters, weekly volatility (standard deviation) of portfolio etc. These are the parameters against which I evaluate my performance every month and do course correction. My remuneration is linked to some of these parameters.
2) All the above mentioned steps of Portfolio and trade management are documented in black and white for reference and remove conflict of interest.
3) For all different strategies and aspect of my wealth management, I have given them names and there are really funny names which makes it very easy to implement them.
4) As all actions (tradewise) are documented. I conduct a monthly audit of these documents and for actions inappropriate or outside the defined parameters of my scheme of managment, penalties are imposed, which include ban from trading for a period, cut in remuneration etc.


Regards,

Dear Oilman,

'Execution' (or say implementation) is one area which has taken many years and money for me to tame. Over a period I have managed to create a system which is devoid of interference of various functions of Trading and portfolio management.

Having read various books on related subjects, the basis of this system is dervied from a very simple and a small book titled - Six Thinking Hats : Edward de Bono. You can find jist of this small and wonderful book on the net.

Regards,

.....................is it on a concept on when to wear which hat?
God!!!!!!!u really a general ,hope even u can be a FM[field marshall]
if time permits , may i be allowed to discuss.
regards for ur excellence
oilman5

The concept is wearing one 'hat' a time and thinking only on those lines what is indicated by the colour of the 'hat'.

Trading, like any other corporate business comprises of various 'people' who are instrumental in running the business (read trading here) smoothly.

In any corporate, you have the core decision making team comprising of the MD, the senior management team - the think tank. Within The think tank you will have Product Development, Risk, Compliance, Legal guys etc.

Then you have a set of field managers, who are implementors/executors whose job is to just sell the product.

In the intermediary you also have Process team, who defines the company's process policies etc and finally the HR team too.

If you define Trading as a "BUSINESS", you will have to relate and allocate all the above roles to different 'people' of this business. But the irony is there is only one indiviudal - "I" who has to do all these roles constanly, day in day out and this is where we fail in initial years in this business as there is a constant overlap, haphazard, random thinking and interchaning of roles which we are not able to define and regulate and ultimately blaming our 'emotions' to the losses we accumulate in the initial years.

Coming to specifics, I run a virtual Corporate entity in myself.

The decision making, implenting, process, operations, risk, compliance, legal and HR is all rolled in ONE person. The only difference is the way all these 'different' people function. And this is where the concept of 'Six Thinking Hats' comes. Each individual function is taken 'INDEPENDENTLY' by physical objects (small toys) which are placed in front of me at a time, which directs to think only on and through that respective roles. Once the outcome is reached it is written on the scrible note and passed on the next role and so on.

I know it may be sounding weird but it works, one can get into a specific role mindset by making the environment look like that and physical objects makes it more easier. Also documenting the outcome helps the cause. For e.g. if the 'decision making team' makes a buy call, defining time frame, drawdown, payoffs etc. it is written on the note and then passed on to the 'execution team'. The role of this team is to just execute as per the instructions written in the note. Post this, they would write a note stating 'job done'. This is just one example which I have stated. This is how the entire machiney works, which includes, operations team, whose job is to ensure that systems, net, broking house matters are taken care without hassles. The accounting team takes care of contract notes, bills, bank statements, charges etc on weekly basis for storage. Any special observations by these 'teams' during their course of action are noted and taken up at the review meeting which is generally on a weekend.

Sounds funny... but it works as the thinking, execution, etc is compartmentalised with no overlap. It is nothing but Keeping it Simple (here it is not necessarily Short, but who cares if this is what works for me well)

Regards,

And also to mention the HR team, which fixes the remuneration of each role, including issuance of memos (for violations) and cuts - ban (gross negliance). Only thing HR doesn't (or can't) handle is granting leave to any specific team, hence all teams/ functions have to work without absentism. When specific milestones are reached, all the functions are given off and there is not trading activity on such 'holiday' .... it's time for fun, frolic and rejoicing.

Regards,

after trade analysis/pms...........in which hat?
i guess it.......combination of some hat,......by the way redhat is always NO in trading.
can u elaborate little bit,.......ur thought process is excellent and there is Totally NO Fouling.
Regards for showing us some light