Risk Management
The main difference between an amateur and a professional trader is that the latter always tries to understand and control portfolio risks. Before entering into any trade, good traders first think about how much risk to take and how much risk exposure comes with a particular trade selection. Only then do they allow themselves to think about how much profit they 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. Is this a better or worse investment compared with others? Without 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 yardstick, 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, return/risk ratio and Sharp Ratio.
Performance Benchmark for FX traders
Since foreign exchange rates are not investment vehicles such as stocks and bonds that have an intrinsic growth potential, there is no readily available and applicable performance benchmarks for foreign exchange traders. The basic guideline for performance is to generate positive returns steadily and consistently with low risks. However, a foreign exchange trader who manages a portfolio of FX instruments can also use a bond index or a stock market index as a benchmarket.
Beta:
Beta is defined as the linear regression slope of a financial portfolio (or a single stock or currency contract), with respect to the benchmark over a specified period of time. For example, one can compute the of a 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 the 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.
In the FX world, we often compute the of one currency rate with respect to another currency rate. For example, over the period of 2/24/2001 to 5/24/2001, GBP/USD and EUR/USD show a positive correlation with a of 0.39.
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"of EUR/USD 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 EUR/USD 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,percent of the time the stock also moves up.
In the FX world, we often compute the of one currency rate with respect to another currency rate. For example, over the period of 2/24/2001 to 5/24/2001, GBP/USD and EUR/USD have a of 0.88, and it means that the two currency rates are strongly positively correlated.
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 applications, 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:
Return/Risk Ratio
The Return/Risk Ratio, , is defined as R/. Generally speaking, the higher the ratio, the better the performance. If we plot the return R against for many different kinds of investments, we get a chart like that presented in Figure 27:
Figure 27 Risk/Return relationship. The line is the so-called "Efficient Market Frontier". Investments that appear above the frontier are considered good. |
Zero-Risk Investment might be likened to a bank account that earns risk-free interest. 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 term periods (say ten years), a graphic representation would appear like a cloud with a rather clear upper boundary. This boundary is the so-called "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. This is to say that, as a consistent strategy, one must take more risk in order to obtain higher return.
Please notice that FX rates are not plotted in Figure 27 because they are not investment vehicles. FX trading is a "zero-sum" game. On average, passively buying currency contracts and holding them does not generate returns. A successful FX trader makes positive returns by trading FX instruments skillfully and consistently. We can also compute the return/risk ratio for the trading portfolio of a FX trader and compare it with that of other traders and investors.
Sharp Ratio
The Sharp Ratio is a measure of a portfolio's excess return relative to the total variability of the portfolio. It is named after William Sharp, Nobel Laureate, and inventor of the capital asset pricing model.
Let the annualized return of the portfolio be R, the risk free interest rate r, and the annualized volatility, then the Sharp Ratio is (R-r)/
The Sharp Ratio is recognized by the finance industry as a good measurement of the ability of traders and portfolio managers. It is equally applicable to equity, fixed-income, FX and commodity traders and fund managers. Most amateur traders will not be able to achieve a Sharp ratio of one. Good fund managers can achieve a Sharp Ratio of 2 or 3 for long terms. Some very talented equity and FX traders can achieve a Sharp Ratio of 5 or 7.
Another Risk-Management concept is VAR, nowadays becoming increasingly popular. Most leading investment and trading houses use VAR as one of their main risk measures in routine risk-management operations. VAR is an absolute risk measure for your portfolio, in units of dollars per day. FXtrek uses the daily 95% confidence VAR definition: this formulation assumes that in a single trading day, there is a 95% probability that the portfolio will not lose more than VAR. For example, if the VAR value is $800, then you can assume that it is 95% certain that the portfolio will not lose more than $800 in one day. Understanding the statistical meaning of VAR is important: a small VAR number does not guarantee that one cannot lose more than VAR; it only says that, most likely--with 95% confidence--one will not lose more than VAR in ONE day.
The calculation of VAR requires the study of the price time series of all the stocks in a portfolio. VAR depends on many factors, such the volatility of each stock, the correlation among all the stocks, and the stability of their historical relationships.
One often hears phrases like "hedge the trade," "hedge the position," "hedge my portfolio." Hedging means the specific 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: First, analyze your portfolio to identify and quantify risks and their sources, Second, in accord with a risk-management system, add, remove, and adjust holdings so that the risks are reduced or neutralized. Third, execute the trades necessary to implement your new portfolio. Sometimes hedging is as simple as selling part of the riskiest instruments in your portfolio, or adding a less-volatile one to it.
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 instrument is sufficiently liquid (active) should you wish to buy or sell promptly. In the FX arena, all top currency rates are effectively "infinitely liquid" for an individual trader's needs.
- Determine the cut-loss level before trading.
- Determine your profit target (take-profit-level).
- Buy the currency contract only at an acceptable price level. Use a limit order when you buy it. At FXtrek, you always buy at the ask price.
- 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 start before one begins a trade. Most important, one must know beforehand how much one is willing to lose, along with how much one can lose in a planned trade. For example, before doing a trade, one should first consider potential losses, study the currency pair by reading news, use FXtrek charts and tools to analyze it, and decide if the stop-loss level is reasonable and acceptable. Only then can one properly determine the currency rate and the number of units to buy. Immediately after a trade is confirmed, enter the stop-loss order to limit 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 5 pip bid/ask spread of the FX rate--you should enter an adjusted stop-loss order to replace the original. That way, the trade will not become a loser if the rate turns back.
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 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 mans 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 one loses ten times in a row, one still retains 80% of one's 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 looked at provide the crucial means of surviving and growing in today's market by applying the same rational controls that keep long-experienced traders ahead!