Oil spills, run away sovereign debt, bailouts, sinking demand in China, sudden 1,000-point moves, and a litany of other factors make managing money today a daunting task. Add to that a global recession that affects markets in unexpected ways and managing money is akin to traversing a minefield. Managing a portfolio is all about managing risk. Risk management protocols are not only essential to successful trading, but are the life-preserving tools of our trade.
The problem is that most risk management protocols were designed to stay in place and provide protection over a set of general circumstances that for the most part remain fixed, triggered only if those elements are breached. What we have learned from recent shocks over the last several years is that things can change dramatically and quickly, revealing holes in our current models. One of the reasons for this is that risk management levels are usually determined, set and then left alone, and some of these levels were set in a market climate that is much different from the one we are in now. This is evidenced by the massive amount of wealth lost across the board from portfolio managers over the last 12-18 months.
Some models have outperformed the top managers and we wanted to know why. What we found was that specific risk management protocols help to limit the downside during times of volatility when most programs were losing ground. These protocols adjusted trade size in real time.
When building models, it is important to be able to capture fluctuations in volume and volatility to the upside while having the flexibility to minimize the same on the downside. Doing this involved one simple factor -- the ability to adjust exposure trade size in real time.
A lot of programs don’t like to do this because it may involve limiting the upside or a complete analysis and reevaluation of the system, elements that the risk protocols were built on. In reality, we are trying to keep those levels constant in a changing world. The upside to adjusting levels of risk is that your trading program now is more representative of your initial intent in terms of market exposure.
Adjusting trade size in real time involves intense monitoring of the markets and a commitment to adhering to your risk management protocols. Think of it like the dial on a radio. Solid trading models that are successful in these kinds of markets should be able to be adjusted to increase or decrease exposure to the markets while still maintaining their root principles. By simply turning the knob down or up, however, managers are able to recalibrate market exposure. Think of it this way: have you ever noticed that volume on a broadcast is higher during commercials? Well if volume is volatility, you are adjusting that volume so volatility remains steady, as opposed to taking on more or less risk due to outside forces.
Because most models have stops either as a percentage or fixed dollar amount, reducing size usually occurs on winners, which allows you to take profits prior to the inevitable drawdown and have a smaller position while the market is going against you. You also would recalibrate position sizing higher when volatility is low.
Without this element, it is difficult for any trading model to have the staying power that it will need to ride the waves of volatility and volume fluctuations that we are experiencing as a result of tepid markets with inconsistent demand and supply curves, which will likely continue until the global recession subsides and we return to a normal cycle.
Let’s take a look at some of the conditions that exist in markets currently that can support the need to have an adjustable trading model where size can be changed on the fly to minimize loss and maximize gain.
What we notice is that at points where volume started to increase, volatility usually increased in either direction (see “Something is brewing,” below). Along with the increase in volume, the price usually will fluctuate as well. We also see the direct correlation between volume, price and volatility where price and volatility move in tandem at periods of increased volume. This is consistent even in commodities, as we examine the evidence of the volume price fluctuation relationship in soybeans (see “Beans on the move,” below). Being able to capture these movements is typically what the average trading model is designed for, but with the risk protocol of changing size on the fly, the portfolio can reduce the exposure to the negative fluctuations while still remaining in tact in its overall dogma. Turning the knob up or down to increase or decrease the amount of exposure is then as simple as monitoring for the volume fluctuations that will set the new limits, which trigger the risk protocol.
The key indicators
The next step is to determine what factors will trigger turning the knob.
One method for making these determinations is to watch the overnight volume. Looking at daily volume levels is not useful because of the massive amounts of day trading. Overnight volume is a more reliable depiction of how much capital is “truly” committed to any market at any given time. Examining the average volume will help you to set parameters for your portfolio by comparing the amount of exposure your trading system takes when it is exposed to the market, and comparing it to the percentage of volume that is typically committed to the market. When these margins start to change, it could be a signal to you that you need to adjust the parameters and turn the knob.
We use the overnight open interest figures to create a base for our volume triggers. Usually we find the correlation between overnight figures and daily traded volume will have a ratio that is consistent and fluctuates in tandem. Recently it’s been roughly 1:2 overnight to daily volume. So by taking a percentage of this volume and using it as the trigger, we are able to use fluctuations in the volume to help tell us when it is time to adjust exposure. We use a 27% trigger. When volume increases 27% we begin shrinking the size of our trade. When it hits 40%, we take our trade off the table completely. On the flip side, if volume decreases by 27%, we increase our trade size by 20%, and then another 20% every 10% volume rise after 27%.
Another extremely important factor in determining when to adjust trade sizes is to watch the correlation of the markets. As we move toward a global economy, we are noticing more and more correlation between various markets due to the cross-investment of global markets as supply and demand curves converge between commodities and currencies.
Even markets that typically display inverse relationships have become correlated and this usually happens at the worst time (see “Things change,” below). The expansion of many companies with international exposure only adds to this correlation as we see markets moving in tandem more often than ever before. What we are seeing now is that because the globalized economy is so prevalent, major markets can move together, sometimes without much notice.
Take a look at the effects that China has had on our stock markets overall, and more directly on commodity prices for raw materials. In a heartbeat, China can put out a report that they are slowing building growth, and markets will plummet, and prices of copper and other building materials will go right along with it. These correlations are important to identify and monitor to adjust trade sizes in real time. These kinds of qualitative indicators can emerge out of thin air and must be watched carefully.
For us, we tend to notice that if the major world commodities such as oil and building materials begin to move in tandem for a period of two weeks, this triggers our indicators to decrease our position sizes. You then realize that although you thought you had a very diversified portfolio of commodities in various sectors, that because of this closely knit correlation of global exposure to supply and demand curves, you have a portfolio that really is quite small.
If you are long grains, metals, energies, the euro, stock indexes and the Canadian dollar, a strong rally in the dollar -- when those markets are particularly sensitive to it -- could teach you a harsh lesson. That lesson could be that you only have one very large position.
It’s almost as though the very definition of “diversification” is changing under our noses. It is becoming increasingly difficult to tell the difference between sector diversification and true movement, and the line is becoming blurred. As we continue to grow as a global economy, more attention to the correlation of the markets, indexes, companies that deal internationally, and the raw commodities’ supply and demand curves is necessary. Having a model that can account for fluctuations and correlations between these is essential to making solid decisions about adjusting trade size in real time to manage risk.
Being able to adjust your exposure in real time should be an element of every trading model. Having a model that is adaptable to trading conditions is one of the strongest tools to keep your risk exposure consistent.
Yiorgo Aretos is CEO of The TMP Group LLC, a CTA & consulting company, and can be reached at yiorgo@theTMPProject.com.