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 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 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.
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:
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.
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.
VAR (Value At Risk)
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
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
- 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.
Portfolio Risk Management
If you actively manage the risk of each trade in your portfolio
according to this single-trade risk management method, your
whole-portfolio risk will be well under control. After all,
a portfolio is just the aggregate of all your individual single
trades. However, it is also important to manage your overall
risk at the portfolio level. The following is a list of key
points for managing portfolio risk:
- Know your overall risk tolerance
before building up the portfolio.
- Determine your overall cut-loss
level. Usually your portfolio should not lose more than
10% of your capital.
- Diversify your investment in at
least three or more different stocks.
- Actively manage the risk of every
- 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!