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.
Using correlation coefficients and beta
In deploying a dynamic risk management plan, credence to market correlations needs to be considered. Markets often don’t trade in their own little world for very long. If you are trading multiple markets, you probably already have an idea of correlation, but you must remember that correlation can be dynamic. Certain events can increase the correlation of certain markets, like last year when the Federal Reserve telegraphed its second round of quantitative easing. A more recent example occurred on May 5 when the dollar reversed more than 100 ticks (see "Strange bedfellows").
HFTs and algorithmic trade programs use a variety of factors in executing strategies. Most are top secret and can be based on many different factors. After speaking with programmers, I found that often strategies start with the use of "correlation coefficients" and the use of "beta."
A correlation coefficient is a statistical relationship between two or more random variables. As applied to investment vehicles, it implies the price dependence differing assets have on one another. The standard measuring tool runs on a scale from 1.0 to -1.0; 1.0 being perfectly correlated and -1.0 being perfectly negatively correlated.
Obviously, nothing in trading is ever correlated perfectly and you always must remember that correlation does not imply causation. Traders need to buy/sell for all different reasons, thus always creating market imperfections. Correlation coefficients can be run in real time, minute-by-minute or basically any time frame.
Another factor that has joined the main stream of trading is "beta." Beta can be defined as the relationship between percentage moves in one particular commodity as opposed to another. In the example used above, if the dollar falls 1%, beta could be used to measure an expected move in silver. If beta is running at 5, you would anticipate silver to rise 5%.
This is a very crude example. Coefficient/beta models can get very sophisticated. However, a basic understanding is important. Beta can not only be a good tool for determining how much heat you can take on a trade, it also helps understand how much profit is possible. Trade programs and quants are heavily into the use of these and often times they dictate the direction and flow of many markets.
When basing a trade on these factors, an exit strategy contingent on when these variables turn against you also should be considered. Know what your market is correlated to. Know also the corresponding beta. Stops should be used when these correlations dip below the desired level. Beta can tell you where the stop should be placed.
Knowing what data may create volatility that you cannot handle is important. Employment reports, Fed meetings, crop reports and earnings related to your investments all need to be considered. Pay attention to each futures contract’s own unique data. Holding positions going into these announcements is risky and should be avoided, especially for positions with short-term time horizons. Whatever your assumption of risk exposure is normally, it should be adjusted during these periods.
Going back and looking at charts to see how futures contracts have moved in the past on specific key data releases can be helpful. Get a handle on range values for past key data dates. How much does your market move on these data? Study this to understand where a stop order should be placed and how much slippage is possible. Of utmost importance is to anticipate whether you can handle trading through such events, both dollar-wise and emotionally.
If your perspective is short-term, discretion being the better part of valor, you should simply step aside during big reports: The Employment Situation Report, Gross Domestic Product, Consumer Price Index, Fed announcements, etc. These often produce whipsaws that encompass both entry levels and stops of shorter-term focused trades in a matter of seconds (see "Stay out").
Traders must consider the liquidity available in each contract traded. Are you trading rice or E-mini S&P futures? Does the market trade one million contracts per day or 1,000? With high-frequency trading many contracts, even some larger markets, can experience large gaps. Knowing daily trade volume average is important. A contract’s trade window on a vertical display can provide clues. How much is on the bid and offer? Is there a bid and offer at every price, or is it spread out? Always know where you can get out. This also is important if you are trading overnight.
Electronic markets are great in that they allow you to trade nearly 24 hours, but most markets are more liquid during their traditional floor hours. You must adjust for greater risk if you hold positions through the less liquid off-hours sessions.
It is important to understand your software in working stops. Some stops include limits, some simply convert to market orders once the stop level is reached; many automatically cancel at the end of a session. It is important to know if these orders stay in or terminate when you are logged off of your trading system. It’s best to never assume any of this and check with your clearing firm for clarification.
While software front-ends may offer certain features, exchanges don’t always adhere to the same features. For example, on a "stop market" order, in general, a front-end will activate a market order once the stop price has been hit. This market order may travel as far as it needs to get filled. Exchanges, however, limit the amount a stop order can travel. If your stop order does not get filled within the exchange parameters, it may get cancelled unbeknownst to you. Exchange rules for each contract can differ, so learn them. You also need to know how the exchange match engine treats each order and what functionality your front-end offers. Is the functionality, say for a stop limit, handled on your front-end that simply enters a market or executable limit order when the price is hit? You need to know this beforehand because it can affect execution.
Another issue facing many traders is whether stops should be changed. The simple answer is never to change a stop order on a losing trade. To do so is often a complete loss of discipline. It may work sometimes, but as most of us have learned, this can lead to catastrophic losses.
What about changing stops on winning trades or the use of trailing stops? Changing stops on winning trades can be effective; the important thing is to apply the same consistent trade analysis as is used in all trades. Getting lax with profits can lead to decisions you would not normally make. Remember to maximize each trade.
It is helpful to trade multiple contracts. This way you can have multiple profit targets. Reach one and take a profit on one contract and raise your stop to break-even. Reach the next level, take additional profit and raise the stop to in-the-money and allow yourself room to run. If your account or allocation allows you to trade one big S&P 500 for every customer, trade five E-minis instead.
Managing trade size, avoiding big losses and maximizing winners is the key to risk management and ultimate success.
After practicing law for two years, Michael Davis became a member of the Chicago Board of Trade in 1991 and began trading. From 2004-2006 he ran a proprietary trading group for Shatkin Arbor, which traded Treasuries, stock indexes and commodities. He has traded electronically since 2002.