Trading Risk: Enhanced Profitability through Risk Control / Edition 1

by Kenneth L. Grant

Overview

Revolutionary techniques that traders can implement to improve profits and avoid losses

No trader, professional or individual, can afford not to have a solid risk management program integrated into his or her trading system. But finding a precise mathematical model to replace subjective decision-making processes is a challenge. Traditionally, risk management has focused solely on loss avoidance, but in Trading Risk, hedge fund risk manager Kenneth Grant presents some-thing completely new—how to manage a portfolio to minimize risk and increase profits by putting more capital at risk. Trading Risk details a risk management program that can help both money managers and individual traders evaluate which elements in a portfolio are working efficiently and which aren’t. By illustrating an extremely simple set of statistical and arithmetic tools this book can help readers enhance their performance in many financial markets.

Kenneth L.Grant is Cheyne’s Global Risk Manager, and is the Managing Member for Cheyne Capital, LLC, the firm’s U.S. arm. Mr. Grant is a pioneer in the field of hedge fund risk management and capital allocation. Before joining Cheyne, he created risk control programs at two of the world’s leading hedge funds, Tudor Investments and SAC Capital, where he was eventually promoted to the title of Chief Investment Strategist. Mr. Grant holds a Bachelor of Science in Economics and Mathematics from the University of Wisconsin, an MA in Economics from Columbia University, and an MBA from the University of Chicago Graduate School of Business.

Product Details

ISBN-13:	9780471650911
Publisher:	Wiley
Publication date:	09/16/2004
Series:	Wiley Trading , #218
Pages:	272
Product dimensions:	6.44(w) x 9.35(h) x 0.85(d)

About the Author

Kenneth L.Grant is Cheyne’s Global Risk Manager, and is the Managing Member for Cheyne Capital, LLC, the firm’s U.S. arm. Mr. Grant is a pioneer in the field of hedge fund risk management and capital allocation. Before joining Cheyne, he created risk control programs at two of the world’s leading hedge funds, Tudor Investments and SAC Capital, where he was eventually promoted to the title of Chief Investment Strategist. Earlier in his career, Mr. Grant led risk management efforts for the Chicago Mercantile Exchange and Société Générale. He is also a member of the Board of Directors of the Managed Futures Association (MFA), and is a founding member of MFA’s Hedge Fund Advisory Committee–the industry’s leading trade relations organization. He is a principal author of MFA’s Sound Practices for Hedge Fund Managers (2000). Mr. Grant holds a Bachelor of Science in Economics and Mathematics from the University of Wisconsin, an MA in Economics from Columbia University, and an MBA from the University of Chicago Graduate School of Business.

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Table of Contents

Preface ix

Acknowledgments xiv

Chapter 1 The Risk Management Investment 1

Chapter 2 Setting Performance Objectives 19

Optimal Target Return 21

Nominal Target Return 24

Stop-Out Level 26

The Beach 32

Chapter 3 Understanding the Profit/Loss Patterns over Time 37

And Now to Statistics, but First a Word (or More) about Time Series Construction 39

Time Units 40

Time Spans 43

Graphical Representation of Daily P/L 48

Histogram of P/L Observations 51

Statistics 53

A Tribute to Sir Isaac Newton 53

Average P/L 56

Standard Deviation 57

Sharpe Ratio 65

Median P/L 68

Percentage of Winning Days 68

Performance Ratio, Average P/L, Winning Days versus Losing Days 69

Drawdown 70

Correlations 73

Putting It All Together 79

Chapter 4 The Risk Components of an Individual Portfolio 81

Historical Volatility 84

Options Implied Volatility 86

Correlation 90

Value at Risk (VaR) 91

Justification for VaR Calculations 92

Types of VaR Calculations 94

Testing VaR Accuracy 98

Setting VaR Parameters 99

Use of VaR Calculation in Portfolio Management 102

Scenario Analysis 104

Technical Analysis 106

Chapter 5 Setting Appropriate Exposure Levels (Rule 1) 109

Determining the Appropriate Ranges of Exposure 110

Method 1: Inverted Sharpe Ratio 111

Method 2: Managing Volatility as a Percentage of Trading Capital 114

Drawdowns and Netting Risk 129

Asymmetric Payoff Function 130

Chapter 6 Adjusting Portfolio Exposure (Rule 2) 133

Size of Individual Positions 134

Directional Bias 135

Position Level Volatility 141

Time Horizon 142

Diversification 144

Leverage 146

Optionality 148

Nonlinear Pricing Dynamics 149

Relationship between Strike Price and Underlying Price (Moneyness) 149

Implied Volatility 150

Asymmetric Payoff Functions 150

Leverage Characteristics 151

Summary 154

Chapter 7 The Risk Components of an Individual Trade 155

Your Transaction Performance 156

Key Components of a Transactions-Level Database 157

Defining a Transaction 158

Position Snapshot Statistics 160

Core Transactions-Level Statistics 161

Trade Level P/L 162

Holding Period 162

Average P/L 163

P/L per Dollar Invested (Weighted Average P/L) 164

Average Holding Period 164

P/L by Security (P/L Attribution) 165

Long Side P/L versus Short Side P/L 166

Correlation Analysis 168

Number of Daily Transactions 170

Capital Invested 171

Net Market Value (Raw) 172

Net Market Value (Absolute Value) 173

Number of Positions 174

Holding Periods 175

Volatility/VaR 177

Other Correlations 179

Final Word on Correlation 179

Performance Success Metrics 184

Methods for Improving Performance Ratios 189

Performance Ratio Components 190

Maximizing Your P/L 192

Profitability Concentration (90/10) Ratio 200

Putting It All Together 208

Chapter 8 Bringin’ It on Home 213

Make a Plan and Stick to It 214

If the Plan’s Not Working, Change the Plan 218

Seek to Trade with an “Edge” 219

Structural Inefficiencies 220

Methodological Inefficiencies 223

Play Your P/L 226

Avoid Surprises—Especially to Yourself 234

Seek to Maximize Your Performance at the Margin 236

Seek Nonmonetary Benefits 237

Apply Liberal Doses of Humility and Humor 242

Be Healthy/Cultivate Other Interests 244

Appendix Optimal f and Risk of Ruin 245

Optimal f 246

Risk of Ruin 250

Index 253