Portfolio Risk Management

Portfolio Risk Management

Portfolio Risk management is the process of identification and modelling of financial risks and the use of statistical methods to control them.

Portfolio management is the science of structuring a portfolio of investments to protect the capital of clients (investors) and generate steady returns in both rising and falling markets. The performance of a portfolio management strategy is measured by its sharpe ratio which summarizes in one number the investment return generated compared to the risk undertaken.

Successful portfolio managers generate sharpe ratios between 1.0 and 3.0 in all market environments including economic recessions and bear markets.

Risk management in a nutshell

Professional traders structure their investment portfolios by having ten to twenty uncorrelated investment positions, with trading timeframe one to three months during normal market risk conditions, identify investment ideas with a risk to reward ratio of 1:3, risk 1% on each trade and use prudent portfolio leverage.

Moreover, they recognize that they are in the business of making money not being right and hence strictly follow their individual position stop losses and profit targets. In trading we should expect at best 30 to 40% of our total number of trades to be profitable. A 30% to 40% win ratio combined with a risk/reward ratio of 1:3 will help us generate consistent returns over time

Their aim is to be consistently profitable over time without been exposed to huge risks.

Retail traders on the other hand do the complete opposite. They have small trading accounts, get high leverage and trade on short timeframes. The result is total financial loss.

portfolio risk management

Portfolio Expected Value

Portfolio managers understand that the expected value of the portfolio depends on this formula

Portfolio expected value = (win %)($ win) – (loss %)($ loss)

In trend following systems and non-high frequency trading systems, portfolio managers achieve consistent returns by winning larger trades few times which are offset by losing trades.

EV = (40%)($3)-(60%)($1)

This assumes the portfolio manager is right 40% of the time but the profitable trades earn 3x more than the losing trades.

Example Expected Value of Roulette

The game of roulette has a $35 pay-out to the winner, but it costs $1 per attempt. There is an asymmetric pay-out 35:1 but is it a good trade?

Expected value = (1/38) ($35)-(37/38)($1) = -$0.0526

Although you win big when you win, the frequency of losses will eat your account. On average, you lose 5.25 cents for each $1 risked on every trade.

Portfolio risk management parameters

Professional traders use multiple parameters when managing an investment portfolio to control downside risk.

When executing a trade, entry is completely uncontrollable by the trade. What professional traders can control however is the position size, his stop loss and profit targets.

Margin Account

Margin is the initial capital deposited in a trading account used as collateral to insure against any losses incurred in the trading account.

Gross Exposure Limit

Gross exposure is the leverage amount of capital of a trading account. For example, if the margin account has an initial capital of $20,000 and the portfolio is leveraged 5 times then the gross exposure of the portfolio is $100,000. Exposure rate or leverage of a portfolio is the leverage multiple of the portfolio. In this case, the portfolio’s exposure rate is 4. Margin call is the reciprocal of the exposure rate. In this case margin call is 25%, that is a 25% portfolio loss will lead to the account’s wipe out.

Professional traders use an exposure rate of five times for Stocks, six to eight times for currencies and four to five times for commodities.

Single Position Limits

Example: $100,000 Investment Portfolio, 1% single asset position limit

A Single position limit is defined as the percentage of total capital risked on each trade. 1% per trade is a prudent position limit used by most professional traders. However, the risk per trade on a single position limit must be matched with the asset’s volatility.

Example:

A trader has an account of $20,000. Assuming a 1% risk per trade the maximum risk the trader can take pe trade is $200. If the trader is willing to trade the S&P 500 E-mini contract he will not be able to do so. The reason is that the E-mini has a 20-day ATR of 21. Each point on the contract is $50 hence the trader should expect a daily volatility of $1,050 in his portfolio for just been long or short. The trader is obviously undercapitalized and should avoid trade the E-mini contract.

1% risk per trade means that a trader must be wrong 100 times in a row to lose his capital.

During high market volatility environments, daily ranges increase hence position sizes must be reduced further (for example to 0.05% per trade).

Single Position Stop loss

The stop loss of a single position is defined by the financial asset’s ATR or historical volatility. Average True range or the financial asset’s historical volatility or implied volatility may be used to estimate the stop loss and profit target for a specific trade.

During normal market risk conditions, our trading timeframe should be one to three months. Calculating the monthly ATR of the investment or the monthly historical volatility we can set the stop loss at 1 ATR or 1 standard deviation below the current price and the profit target at three times the ATR or standard deviation above the current price.

Risk/Reward

Professional traders only invest when the odds are in their favor. They look for investment ideas with a probable reward at least three times greater than the objectively measure potential loss. In trading we should expect at best 30 to 40% of our total number of trades to be profitable. A 30% to 40% win ratio combined with a risk/reward ratio of 1:3 will help us generate consistent returns over time.

Correlation of assets

Portfolio managers minimize their portfolios volatility by structuring the portfolios with uncorrelated return streams.

During big moves and elevated market risk, correlations increase between asset classes and hence diversification becomes harder to achieve. During crisis as they say “correlation becomes 1”.

Hence, it’s very important to monitor rolling correlations of assets constantly and adjust the portfolio’s exposures accordingly.

diversification strategy

Time loss

Professional traders use time losses to avoid dead money. If something stall for three to four trading days then close it.

A professional trader is a full-time trader working in an investment bank or hedge fund whose primary role is to manage their clients’ money and earn the best risk-adjusted return on capital.

Portfolio management is the science of structuring a portfolio of investments to protect the capital of clients (investors) and generate steady returns in both rising and falling markets. The performance of a portfolio management strategy is measured by its sharpe ratio which summarizes in one number the investment return generated compared to the risk undertaken.

Successful portfolio managers generate sharpe ratios between 1.0 and 3.0 in all market environments including economic recessions and bear markets.

The aim of portfolio managers is to generate consistent adjusted returns with high sharpe ratios, compounded over many years to generate growth and wealth creation

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