› Risk management in trading

Risk management in trading

This article is about how to prepare risk management programs and how to use them in practice. The key idea is to create a strategy which will help you to save your capital and increase income.

Even though this idea could not be applied to all strategies and all markets, it often happens that keeping a reasonable combination of put and call options in your portfolio is useful. That's especially fair for those portfolios which include separate instruments vulnerable to mutual correlations - for example, those kinds of assets which are focused on shares or any other related securities and commodity futures. With all other equal conditions (especially regarding factors related to leverage size in the portfolio), a balanced combination of put and call options is less risky compared to situations when all obligations are dependant on just one side of the market. For instance, a portfolio containing call options for corn in most cases would be less risky per unit than a portfolio which contains only put or only call options for the same commodities. At the same way as an account with call options for IBM shares and put options for Microsoft shares probably would be less vulnerable to potential risks than an account with the same shares on one side of the market.

As long as the portfolio volume is growing, the need for operating on both sides of the market becomes more obvious, and it's strongly recommended sticking to such a double-sided market orientation as that's one of the best ways to maximize profits with the risk adjustment. However, this problem appears to be one of the most difficult in portfolio management nowadays, as experienced traders notice. That's related to the fact that the vast majority of traders, as well as major markets, are keen on more one-sided market orientation. For example, it was much easier to trade on the bull stock market side in the middle of the 1990s. Reasons are quite simple. First, the market was in a sustainable and continuous growth mode in that period after the previous decline. Second, the equities market, according to general conditions, is structurally organized in a way that they are favourable to call-option bets with the help of such mechanisms as 'plus-tick' for short sales, rather complicated conditions related to short sales loans of shares and the rule, according to which large and institutional portfolios are forced to operate exclusively on the call-side of the market. We have to keep in mind that if results were reviewed in the scope of their extreme values, then a put-option deal is am asymmetric bet, the income of which is limited by the fact that the price cannot be negative, whereas potential losses, theoretically at least, aren't limited by their nature as the upper range of the cost for trading shares does not exist. However, futures markets are supposed to have a different point of view. Futures traders tell that it's much easier to trade on the put-side of the market, although those guys cannot be blamed for excessive optimism ever.

Call Option vs Put Option
Source: Call Option

Although that might seem to be tough from the psychological and practical point of view, that's extremely important to try working on both sides of the market wherever it's possible because of the potential benefit of such an approach significantly overweighing uncomfortable nuances related. First of all, most of liquidity providers feel calm when funding portfolios with two-side market orientation compared to a situation when they are forced to invest in risks related to one side of the market only. There are doubts though, that based on pure risk management considerations, this methodology is reasonable (one of the key principles of risk management is based on a calculation that one risk-dollar expressed in one way is worth the same risk-dollar expressed in a different way) but such a double approach is definitely softening some event risks, for instance, the risk of call-option trading for insurance companies when aeroplanes crash into buildings.

Moreover, whatever pace of external limitations for volatility your portfolio faced (it's a huge challenge by the way), one of the wonderful ways to manage appropriate risks is reaching a certain balance of call and put options. Portfolio management, from the point of view of choosing the balance of put and call options, is also a very useful instrument to control risks in those cases when you hope for getting benefits from correctly determined 'informational trigger' (for instance, from goods description), even though you're not sure when exactly is the best time to use that catalyst. In such cases, using the balanced methodology in portfolio management will provide much more opportunities in supporting your deals in a period of unfavourable market conditions which can start before the informational trigger will make his job, affecting the price action of those instruments which you are targeting.

There is one common misleading here. Many seem that it's necessary to get profits from both sides of the market in order to trade on the balance of put and call options successfully. Although with other equal conditions, such a result is desirable, it's possible to get larger profits, trading on comparatively balanced market orientation, even if you get a no-loss level or small level of losses on one side of the market where it's less comfortable for you to trade. As it's been already said, you lower risks that way, in case of unexpected market events like a catastrophe, for instance. If the portfolio is totally oriented to one side of the market, then it's vulnerable to similar episodes' impact with all of the power and beauty. And as a result, in most cases, all shares will move in one direction at the same time. Maybe it's more important that the existence of a definite, well adapted, double-sided protection of financial risks would significantly enlarge your skills to make your best trading ideas real - in any market cycle - and benefit on situations when you count on the high likelihood of events developing in a certain way but you;re less sure about when it's going to happen.

Let's have a break for a moment and carefully consider the statement that the orientation for put and call options also lowers the need for choosing the absolutely exact moment for trading operations on the market (meaning the 'market timing' term). From experienced traders' point of view, it's much easier to make money using well-established ideas in terms of separate assets, especially those, in which you have predetermined advantages, than trying to guess how the market will behave in general - would it start climbing or declining. If you decided to focus on specific assets like separate shares or commodities, then the most profitable deals will be those which you've opened a bit earlier, meaning before the moment which you've chosen as the perfect one. In such cases, deals on the other side of the market will protect you from the generally unfavourable market momentum which could take place before the event you hoped to benefit on. Such tactics are extremely important as if you stick to it then you could be vulnerable to a risk to fail with your very best trading ideas due to the market's hyper-sensitivity to macroeconomic conditions. If you're a constant victim of such circumstances then you do nothing but waste your time and efforts.

In general, if you don't have a magic crystal ball able to exactly predict the future, then there are just two options available in relation to your trading ideas: whether you will come before the party starts or you'll be late. Most traders have enough experience and common sense to admit that the second option is simply unacceptable as being late means the deal is wasted. Consequently, it could be necessary to enter the market a bit earlier than the 'perfect' moment, from the profit/loss ratio point of view, for the vast majority of your successful deals. If you were looking say postfactum at the issue. Two issues would become the direct consequence of that. The first one is the deal volatility problem. Second, concern about your correct choice still remains, If you were able to manage both issues (and if your choice was generally right), then, rephrasing Rudyard Kipling, 'the whole world you accept as your own", making additional money at the same time.

In fact, if you were able to master the risk-control skill and learn how to implement your best ideas beforehand, then you would get an opportunity not only to turn those ideas into cash but also maximize your profits by enlarging the trading volume and getting your deals to the most profitable levels. That's exactly the approach which is diminutively called 'averaging' in the financial markets. Of course, that's a risky method and it's used by experienced traders only, who (1) are 100% confident that the trading idea is profitable; (2) dispose of deep enough risk capital to withstand the fight till the end and (3) gained appropriate experience and skills to manage that process in the right way. Although that's not the exact topic of this article and averaging should not be recommended to anyone except highly educated and experienced traders, this concept is indicative enough in the scope that it illustrates how effective such trading technique could become for those traders able to control risks. More importantly, the double-sided market orientation is an extremely useful approach for those trying if not even implementing the averaging method to some promising attractive deal without a determined profit period but at least keeping a certain level of risk vulnerability in trading.

Let's have a look at a rather common example. There are rumours that you're interested in a pharmaceutical company named XTC, which, as you're completely confident, should get FDA approval shortly for a medicine manufacturing which cures depression and sexual potency at the same time (of course, that's unnatural but theoretically it's possible). As far as you usually use rather a scrupulous analysis for this kind of things, you made in-depth research of clinical tests data, you read everything that FDA published about that stuff, you talked to doctors who told you that this medicine is a huge breakthrough in science, and you analysed all financial figures. Damn it, there are rumours that you even took part in clinical tests, trying that medicine on yourself and the result was tremendous.

Of course, you prepared well enough and it seems that you have a certain advantage. But the trick is that some people who invest smart money are confident that FDA will send the XTC miracle-medicine for revision this month. Moreover, according to the latest data, the overall pharmaceutical market struggles to keep the upside momentum, seeking direction. In general, the equities market is very volatile and some analysts suppose that it can crash at any moment. All that makes you nervous but you are totally confident that XTC will get the FDA approval and when it happens, its shares will soar twice the current price. The only problem you have here is that you don't know exactly when the FDA approval will happen.

How could you hold your position long enough until the company will get the approval and you were able to finally make money off that? The approach this article describes is exactly the thing you need, combining put and call options. Maybe you should open new deals for some pharmaceutical companies which do not have such an informational catalyst. Let's finish the example: try to imagine another small pharmaceutical company which appeared after the merger of two separate medical corporations - Lucy Companies and Skye Corporations, which acquired another firm - Diamond Pharmaceuticals. As a result, the company Lucy, Skye and Diamond Corporation was created. Its shares symbol is LSD and this company is awaiting regulators' approval for medicine which makes people flying (or just imagining that they can fly, you don't remember exactly). Now let's assume that you made similar research as for XTC that FDA officials are not rushing to approve LSD medicine in the same way as XTC medicine. What a wonderful pair this is! If you were buying put options for LSD shares, that would have helped you to hold the XTC deal in any conditions - the overall market or this particular sector - and turn your brilliant idea into the reality, making money on XTC shares when the company received the FDA approval.

On the other hand, if you were holding call options for XTC and LSD shares at the same time, then the consequence would have been much more dramatic, everything might get out of control, and it could have happened that you would be forced to get rid of both positions too early and that would not be good from any point of view. If there is no LSD (or any other similar equivalent) in your portfolio, then you could buy put options for a DRG index in order to reach the target. That index would be kind of hodgepodge which consists of pharmaceutical shares and it's traded on New York Stock exchange as a single derivative. Even if that is not accessible then there is always an opportunity to buy put options for the wider market, for example, the S&P 500 benchmark and that would protect your position in some (if not all) situations which would have forced you to eliminate your favourite XTC position too early.

If you are able to hold the XTC position until the long-awaited approval is done, then you can start celebrating the victory whether you closed LSD, DRG or S&P with profit or loss. Having a look at the situation from a side point of view, at safe distance from managing a portfolio, it's easy to understand how the double-sided market orientation, with which one position works as the risk protection tool, could influence getting higher profitability with the risk adjustment, compared to the situation when all deals are focused on one side of the market, put or call options. Moreover, it would be logical to reach an aggregated profit/loss ratio’s negative value for the hedge side of the market. However, the experience tells that those factors do not play a comforting role for many portfolio managers who are mainly worried about the loss of the hedge side rather than situations when brilliant ideas turn into negative profit/loss ratio. That common psychological phenomenon is related to the human nature of keeping strong emotional correlations to own things and ideas. This is why traders often don't pay attention to small but stable profits from technically correct deals but worry about possible failure of their brilliant ideas.

Working with a balanced portfolio is very time-consuming. It happens that most part of the time has to be spent on searching for appropriate hedging instruments in order to make the portfolio management effective. That process is more complicated than the first impression just because you need to choose assets able to protect you from negative events' influence keeping the opportunity to end up with profits if the informational trigger will exhaust itself. Unfortunately, hedging success factors aren't always opposite to your straight positions pointing to your best opportunities. Choosing hedge positions is often more complicated than generating a trading idea which is supposed to be protected from risk factors by the hedging. Nevertheless, the double-sided method is extremely useful for thse traders who seek to protect their primary positions and implement risk control practice in trading.

If you like Risk management in trading, you might also be interested in this Best Binary Successful traders’ tips

Read also

You have successfully registered

You can choose the needed type of account at any time!