The Risk of Trading

Mastering the Most Important Element in Financial Speculation

Michael Toma

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9781118100837
• eBook ISBN: 9781118237106
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Develop the skills to manage risk in the high-stakes world of financial speculation

The Risk of Trading is a practical resource that takes an in-depth look at one of the most challenging factors of trading—risk management. The book puts a magnifying glass on the issue of risk, something that every trader needs to understand in order to be successful.

Most traders look at risk in terms of a "stop-loss" that enables them to exit a losing trade quickly. In The Risk of Trading, Michael Toma explains that risk is ever-present in every aspect of trading and advocates that traders adopt a more comprehensive view of risk that encompasses the strategic trading plan, account size, drawdowns, maximum possible losses, psychological capital, and crisis management.

• Shows how to conduct a detailed statistical analysis of an individual's trading methodology through back-testing and real-time results so as to identify when the methodology may be breaking down in actual trading
• Reveals why traders should think of themselves as project managers who are strategically managing risk
• The book is based on the author's unique 'focus on the risk' approach to trading using data-driven risk statistical analytics

Using this book as a guide, traders can operate more as business managers and learn how to avoid market-busting losses while achieving consistently good results.

PART I

Principles of Risk Management

CHAPTER 1

Foundations of Risk Management

The golden age of corporate and accounting scandals during the Enron era placed risk management on the lips of the average corporate employee. In an attempt to mitigate future scandals, the U.S. government passed the Sarbanes-Oxley Act in 2002. The U.S. Senate called it “The Public Company Accounting Reform Act,” and the House called it the “Corporate and Auditing Accountability and Responsibility Act.” I'll refer to it by its simple hybrid name, SOX. This legislation is at the heart of risk management today, so it's vital to begin any discussion with a little history. The goal of Chapter 1 is to provide an introduction to risk principles, which you will use in your day-to-day trading activities.

A BRIEF HISTORY OF THE LEGISLATION

The SOX Act brought new regulation to corporate board member responsibilities, oversight of accounting practices, corporate governance, fraud, internal controls, and enhanced financial disclosure. While there are debates over the effectiveness of the actual bills, mostly from cash-strapped companies that find the cost of SOX compliance to be more expensive than paying the fines, the need for managing risk has bubbled to the surface as one of the must-do's on the corporate budget sheets. Many companies that are not required to comply with SOX attempt to be within compliance due to the best-practice models inherent in the act's bylaws. Other risk control standards, such as the SSAE 16 assessment championed by the CPA community, also adjusted their prize audit standards in an effort to put on a cleaner pair of SOX.

Since the meat of the act involved the proactive identification, assessment, control, financing, and monitoring of risks, what better individual to implement such a monster than your risk management professional. Since 2002, a more holistic form of risk management known as enterprise risk management (ERM) has grown in popularity. Rather than just identify problems, the ERM specialist can also be viewed as a process improvement and efficiency resource that can assist in improving the bottom line. Technology, database management, data analytics, and the use of data-driven decision making has also resulted in a greater acceptance of the ERM framework. Along with a never-ending surge in data technologies, business analytics, and the sudden urge to measure everything that's measurable, the two have brought risk management to the forefront of today's trading. Many of these ERM models continue to grow in popularity and have a nouveau-risk appeal. Quickly fading are the more traditional risk models that have stuffed the file cabinets of institutions that see risk management merely as insurance policy management.

Using math and numbers to make proper trading decisions should be simple and transparent in communicating the value proposition for using such methods. There has been a dramatic shift in focus over the most recent decades regarding the application of financial risk management. It is important to be clear that the risk principles and theories noted earlier are a critical requirement in your ability to be successful. During the same time, data-driven decision making has accelerated the thirst to incorporate risk management into trading decisions and now is a critical component of any institutional process. In other words, “what is the data telling us?” is equally as important in directing managers on what to do as relying solely on theoretical and strategic methodologies. Many of the texts focus on trading theory only, and I find myself being extremely critical of this information when used in a live environment. The common securities industry phrase “past performance is not indicative of future results” may have some merit (particularly from a firm's legal perspective), but data analytics is founded on the principle that patterns or behaviors tend to repeat when similar market elements are present.

The term risk management has been used in an ever-increasing fashion in recent years. Regulatory changes, the need for greater compliance-based operations, the increasing cost of loss, and evidence of its impact on the bottom line has fueled discussion points on the previously closed-door topic. This chapter introduces the elements of risk management and the steps used in the process. We will also review the benefits of infusing risk concepts into your trading plans and operation.

It's important to note that people see risk differently in their professional roles. Of course, we focus our discussion on risk within the scope of a trading environment. Those in the mortgage industry, particularly underwriters, may see risk as the potential default on a loan. Mortgage brokers may see an increase in the fixed rate as a risk to their business, knowing that an increase in mortgage rates would slow demand. At the same time, other brokers may like a spike in rates that create a demand to lock in low rates or opportunities to convert those with adjustable-rate mortgages to a fixed-rate plan. Still others in the industry may see the regulatory agencies as their biggest risk since the passing of stricter processes or disclosure may hinder their ability to generate revenue from specific market segments. This was exemplified during the aftermath of the 2008 mortgage crisis when mortgage brokers were required to stick to tighter regulatory processes as part of the lengthy Dodd-Frank bill. In a hospital operation, a surgeon may see the primary risk of a procedure not working or even the death of a patient, while upstairs in the administration department, the risk of rising medical equipment costs may be on the identified list. Down the corridor, the legal department's top monitored risk is the public relations plan gaps that may be exposed during a crisis. As we progress through the risk management process, it is important for readers to establish their operational trading goals before actually identifying potential trading risks. Let us first define risk, at least within the context of a trader, before we proceed to determine how to manage it.

DEFINING RISK AND RISK MANAGEMENT

Various definitions of risk management are used depending on the industry, source, and purpose. For example, corporations tend to use a definition to define the purpose of their department with the same name. Others use their department's mission statement as the foundation for how the term is defined. The basic theme for most definitions of risk management includes the decisions made to protect the entity's assets and minimize the adverse effects of activities we perform in order to attain company goals. In the trading world, the term assets can refer to many things. Logically, our trading capital is probably one of our most essential assets. Capital in trading is the ticket to the show. Simply put, if there is no capital, there is no business; hence the important link of risk management to capital. Later we will discuss the risk identification process in depth. It is critical to also define the logical classification of a trader's capital or related company assets before the risk management process takes place. If not, how can we protect an asset that we haven't identified as an asset?

If risk management is based on the premise of protecting assets, we need to understand the term risk, bypass the lip service often given to the term, and define it, at least within the scope of this text. Being a professional risk manager and trader for many years, I've come across several definitions of this simple yet complex word and would probably receive 10 different definitions of the word if I asked as many people. The best definition that reflects the purpose of pure risk management and maintains its simplicity for explanation purposes is simply the chance or uncertainty of loss.

Pure vs. Speculative Risk

The trading community is certainly aware of the chance of loss on any given trade or trading strategy. We accept risk not so we have the opportunity to engage in risky activity (although our business is a magnet for those who relish risk taking), but to reap the opportunity of rewards or capital gain. The scope of pure risk is limited to those activities and decisions undertaken to avoid loss without the rewards found in speculative risk taking.

The insurance industry is based on an individual or entity's need to reduce loss without any opportunity to benefit from an event or decision. The term used in insurance is indemnification, or “to make whole.” If you review homeowner, auto, or similar policies, you may not have to search deep to find the words indemnity or indemnification. Many have it as the first word on the policy right on top of page one. The basis of indemnification is to bring the owner of the policy's asset or use standard to where it had been before the loss. A car gets repaired, a home gets rebuilt, or stolen property gets replaced. Even in life insurance, the value of the policy is considered indemnification to the beneficiary, at least for policy definitions, upon the demise of an individual.

Speculative risks include a chance of indemnification plus additional gain. The desire for this gain is offset by the potential loss that may occur. The gaming industry is a perfect example of speculative risk at work. Companies allow customers to partake in speculative ventures, described in their eyes as entertainment. Casinos and financial markets provide the forum for speculators to execute their speculative risk-taking activities. In an ironic twist, both industries would be nonexistent if the speculator did not benefit from time to time. While reducing player odds in a casino would greatly benefit the house in the short term, these companies know that there needs to be the potential for speculation to pay off, whether it be in winnings or entertainment value, to maintain solvency. Gaming companies are experts in statistical probability, valid sample sizing, and mathematical edge, the same formulas used by successful risk-based traders.

As you read through the book, it is important to remember that although traders are generally placed in the box of speculators, they are subject to both pure and speculative risks. We limit our loss on a trade with the intention of making a profit of the same or even greater amount. This is speculative risk in its simplest form. A trading platform crashing in the middle of a trade can only be defined in the pure risk category. It is this lack of inclusion of both pure and speculative risk types in the risk management process that is one of the biggest identified concerns in my auditing work.

Scope of Risks

When performing risk assessments in the trading community, I frequently widen the scope of the pure and speculative risk definitions noted above. It's normal for traders to be concerned about their performance and desire to continuously improve. After all, that is what puts bread on the table. In determining chance of loss or level of uncertainty, always incorporate an element of variance into the definition of risk. In other words, risk is also the possibility that any outcome may be different from an expected outcome. For example, a trader may be extremely satisfied with reaching his or her profit goals for a defined period. A risk manager will assess the variability in outcomes that had resulted in the profit goal. Perhaps the trader took on too much risk or violated trading rules to obtain the goal. Maybe the goals are too conservative for the trading instrument or share size is too large, thus allowing the trader to easily reach the goal and allow psychological comfort for that period. As we walk through the risk management process, please be sure to consider the possibility of a variation of outcomes that may differ from the intended result.

CLASSES OF RISK

Although we will devote intensive study to risks directly impacting traders, such as trade risk or the potential for loss on a trade, it is common to find other classes of risks that typically impact traders’ performance or overall business at least once during their careers. Here are some classes of risks that tend to be overlooked by the typical trader.

Industry Risks

Exposure to trends in the financial marketplace or financial structure often can impact traders’ ability to meet their goals. Changes to instrument liquidity and bid/ask spreads can make a dramatic change to a trader's bottom line. Competitive product releases, particularly in the exchange-traded funds (ETF) community in recent years, while allowing a supermarket of trading choices, have also have resulted in i...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Preface
• Acknowledgments
• About the Author
• Part I: Principles of Risk Management
• Part II: Managing and Measuring Risk
• Part III: Qualitative Elements of Risk
• Bibliography
• Index