Practical problems in risk management

Last Updated: Mon, Dec 10, 2012 03:50 hrs

pGamblers bet a portion of their total capital on every wager It is indispensable for a gambler to know how many successive losses they can sustain before being wiped out This helps them work out the optimal size of each betppThis is also a very useful calculation for a trader In a trade the potential loss depends on the leverage and volatility of contract To a certain extent losses may be controlled by stop-losses But in a market running against you the stops may be broken with gapsppMost experienced traders are uncomfortable with trades risking more than about one per cent potential loss of capital A highly aggressive style may risk say two per cent of capital per trade Its reasonable to expect slippages in exiting losing positionsppAlso most traders have several trades out at the same time A stop-loss can be missed On a bad day several stop losses may be missed at the same time So capital can evaporate very quickly if there is a succession of lossesppThis is why position size is important and so are multiple methods of potential loss calculationsppThe simplest calculation of maximum potential loss is the widest daily high-low range of a given period This is the maximum volatility experienced If a trader suffers one terrible session or perhaps two bad sessions losses may hit this levelppThis is a conservative calculation but its not very practical for setting stop losses because the widest high-low range may be an outlier Where and with what logic do you set stop losses Some traders set stops purely on support-resistance levels This doesnt work well in trending markets where an adverse move may smash through the stop lossppOther traders use average high-low range calculations or the average true range ATR to set stop-losses An average range is an average of the daily high-low range over a given period The trader may set that as a stop-loss Or he may set stops at a multiple of average range x2 or a sub-multiple x 05 if hes a day-traderppATR is a more complex calculation though its directly available from many trading packages and easy to program The &ldquotrue range&rdquo TR of volatility in a given session is taken as the largest absolute difference of the following three calculations A high minus low of the given session B high of session minus previous close C Low of session minus previous close This covers everything from an extremely volatile session with a wide high-low difference to a jump or a drop or a flat session The ATR is an average of the TR over the given period the initial sessions TR is taken as high minus low Traders use multiples and sub-multiples of ATR for setting stopsppThere are a couple of other scenarios which experienced traders try to assess for potential loss One is correlated losses If youre holding positions highly correlated to each other the chances of big losses rise All the positions could go bust togetherppFor example if youre trading only banking stocks and theres a change in interest rates all your positions will move in the same direction On the other hand if youre holding non-correlated and inverse-correlated positions this is less likely Its worth keeping an eye on correlation though this will have large error factorsppAnother situation which some traders try to assess is &ldquoblack swan&rdquo impact Some unforeseen event like an earthquake or terrorist strike may cause huge volatility How much are your favourite stocks likely to swing on such a day Again large error factors are involved but you can guesstimate from previous Black Swan daysppSet stop-losses with reasonable assumptions and keep an error margin for the unusual If your calculations imply a given contract carries unacceptably high risk of loss its better to avoid it It all sounds easy and common-sense But most traders only learn from experience how difficult it is to put risk-management into practicep

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