From the July 01, 2010 issue of Futures Magazine • Subscribe!

Risk management, position size and your portfolio

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.

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