From the June 01, 2011 issue of Futures Magazine • Subscribe!

Risk management in an ever-changing environment

Managed Money

Managing futures risk in today’s high-frequency trading environment is a constant challenge. The act of simply placing a stop order in a single market to protect against danger has become inadequate.

Algorithmic high-frequency programs are on a constant seek-and-destroy mission to force stop orders to be executed. Put your stop order in at breakout points, daily highs and lows, or just below or above clearly defined trend lines, and you often see stops executed in a flash, only to see the move anticipated continuing on as if nothing happened. Does this sound all too familiar? Even when keeping your stops away from high-traffic areas that can lead to slippage, you need to work slippage into your models and risk management approach. Assume a certain amount of slippage into each trade and only decide on a strategy that has tested well after assuming this slippage.

Risk management may have been an issue of discipline in the past, but now it requires more research and a more dynamic process. Drawing from my own experience and sharing ideas with other traders, successful plans all have common similarities to the basics that follow.

Don’t be overleveraged

Traders need to match their trade size with their account size. The best systems will experience hot and cold streaks and there is no telling which will come first. An individual trader should never risk more than 10% of his account on any given trade. If you are managing other people’s money, that probably should be 2% or 3%.

Identify your trade

Getting long because you think it’s going up, or short because you think it’s going down is simply winging it. Increased volatility, perhaps from high-frequency trading, has increased margin requirements. Algorithmic programs can make markets travel up and down range extremes several times at light speed without giving traders much time to make key decisions. So, if you are fundamentally driven, you still must understand technicals.

Even short-term technical traders should make sure they are trading in the direction of the longer-term trend, or at least be aware of it and set stops accordingly.

Traders always should ask, "Where do I think the market is going?" That means specifically anticipating an exact price. Next, and most importantly, ask, "Where do I know I am wrong?" Again an exact price, but one anticipating a certain amount of slippage. At this point, the trader must ask if this trade makes sense on a risk/reward basis. This sets up an order cancels order (OCO) option.

Technical methods as risk tools

The trading world is saturated with technical methods that dominate trading on an intra-day and even long-term basis. Even the best fundamental ideas are likely to flounder unless entered with an understanding of important technical levels. The best traders pick an idea and wait for "the stars to be aligned" before jumping on board.

There are many technical methods available. None work all the time; the best work more often than not. A basic rule here is to match your technical method with your trading time frame. A 60-minute chart can be great, but doesn’t offer much help if you cannot hold the trade overnight or margin requirements are a problem. Your trade entries must be based on a time frame that allows a reasonable variance in price. The longer the time frame, the wider the reasonable stops. If it is beyond your risk threshold, you must base trades on a shorter time frame or reduce your size.

Whatever your trading idea , executing with an "OCO" strategy ensures you are following your method. To do otherwise means to break from your plan.

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