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Quoting rockit
{quote} Truth is that a trader might not understand the reason, but not that there is no (apparent) reason or that it is against rational. "Markets" care about volume and price, while retail traders usually stare at time-based charts, which mean nothing to "markets", and might not have access to the volume distribution along the price scale, i.e. in forex.
Hi rockit,
Agreed, the majority of my experience is in equity markets and there volume does tell you something extra. I assume all liquid, freely traded market are similar, the problem in retail forex is that the volume is not so easily observable.

To be honest, I'm not sure exactly what markets care about, it seems to me they care more or less about different things at different times. Rather like fashion! Over time I have come to cut a simplifying knife through all of this and just look at price action, not the reasons or the volume. Price will tell me what I need to know efficiently enough and, moreover, it is price that I actually trade in, not volume or news nor anything else. Once you start widening your horizons it is too easy to be caught in conflicting waves of information so I just stick to price, imperfect as it may be, and work with that.
Hi all,

Risky Business

Whilst posting recently on another FF thread, it was pointed out to me by a fellow FF member (zkchyo, to drop a name) that I spend an inordinate amount of time rattling on about the importance risk management and how trading is ultimately all about the control of risk, so would I like to expand on this topic? I plead guilty as charged and thus the next few posts here will attempt to do just that.

Let’s start by posing a few obvious questions:
- What is risk, anyway?
- Why is it important to a trader?
- How can we effectively go about managing it?

I’ll look to answer each of these questions in turn in the following posts. I’ll also add afterwards for comparison and/or general interest a bonus post about how major institutional investors go about the same task.

Enough introduction, the next post will start by examining what is risk and why is it important in trading.
1. What is Risk?

Risk. A common word we all understand but what does it really mean? If you start thinking about it I’m sure you’ll soon be coming up with lots of related but subtly different definitions. Even if we stick to the narrow world of financial speculation a quick search will find explanations such as:

  1. The possibility of losing some or all of an original investment
  2. The chance that an outcome will differ from an expected return
  3. The volatility of an asset price in comparison to its historical average

Most people I think would think of trading risk along the lines of the chance of losing money from an investment. Fair enough. So what has expected return and volatility got to do with it all? This is where the academics got on board and starting thinking about investment risk a little more deeply and statistically. They began with what is considered a risk-free investment, typically a bank deposit or government bond (before all you financial theorists out there start reminding me there no such thing as a totally risk-free investment, yes, I get all that, but some simplification for the benefit of clarity is what I am going to progress with here).

In this sense, risk-free means no chance of losing money. The money in the bank is safe (let’s have some trust here!) and your bond is guaranteed by the government (more trust!). You will get a positive rate of return with no chance of losing. It’s risk-free. But the return won’t set your socks on fire, after all you are taking no risk. If you want higher returns you are going to have to assume some risk, accept some possibility that you might actually get a negative return for your efforts. You expect a positive return - otherwise a rational person wouldn’t make the investment - but the outcome may be different to that expectation. The outcome could of course be better as well as worse than expected but we ordinarily would not think of a windfall gain as a risk. But the killjoy academics do. To them it’s just return volatility and it’s all the same to them if it’s positive or negative.

So, risk in a trading sense involves the idea of an achieved return that is volatile around the expected return when the trade was placed. Higher volatility = higher risk and this neatly leads us to the next post of why risk is an important consideration for a trader.

  • Post #24
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  • Edited at 6:18pm Sep 30, 2021 5:53pm | Edited at 6:18pm
2. Two Sides of the Same Coin

The previous post hopefully got you thinking a bit more deeply about the idea of investment risk. But so what, why is it important enough to wear out some precious brain cells over? Because risk and return are two sides of the same coin. They are inherently intertwined and there is no separating them.

We can summarise our knowledge so far by saying:
No risk = low volatility = low expected return
Some risk = some volatility = higher expected return
High risk = high volatility = fantastic expected return

Great! Pile on the risk, please, I want to be stinking rich asap.
But, sadly, and as you knew all along, there is a catch. Expected returns are not actual achieved returns. Due to risk essentially being two-way price volatility, i.e. price can move up or down, things may not work out as planned and you can lose just as easily as win once you start assuming risk. A two sided coin.

I trust you are getting an inkling now why risk is important to a trader. You can think of it as just negative profit and the difference is that whilst positive profit is nice and harmless, negative profit - aka risk - can kill you, your account at least. This, in essence, is why I endlessly rattle on about trading being the management of risk. Anyone can survive being presented with a profit but being presented with a loss can be fatal. It’s a two sided coin but one side is is more dangerous to you and so worthy of more attention than the other. I’m not saying you shouldn’t have a well thought out process for booking your profits, you must, but you have to think about trading more as the control and management of risk than of profit because of the damage it can do to you.

If we can design our trading so that we happily accept the positive volatility, the profits, but somehow control and mitigate the negative volatility, the losses, we are going to make net money. As Andrew Carnegie, the 19th century industrialist who from a standing start became one of the richest ever Americans said, “Watch the costs and the the profits will look after themselves.” Subsitute losses for costs and we have an excellent mantra for approaching trading.

So, in the first post we got to know what risk is and in this post we got to understand why it is important to manage it, why trading is best thought of as the management of risk. In the next post we shall look at the very practical question of how we might usefully do this?
3. The Management of Risk

Trading is a pretty simple game at heart: you buy something, it goes up or down, and then you sell it. All you need to do is decide when to buy, how much to buy, and then when to sell it. A buy signal, a position size, and a exit decision. That’s it all, no rocket science anywhere. But as soon as you buy you are exposing yourself to risk, to price volatility and, as we found out last post, it can be fatal. So we need to manage this risk really well.

This can be done, conceptually at least, in a couple of simple ways. Method #1 involves having more trades that result in positive volatility than negative, accepting the same maximum tolerable amount of volatility each way. Think 1:1 R:R trading with a success rate >50%. Method #2 involves letting the positive volatility do its full thing but chopping down on the negative volatility once it gets to a certain maximum tolerable amount. Think running winners and cutting losers. You can look to combine both methods if you wish (and you probably should at least try).

Notice what is common in both cases: that there is set a maximum tolerable level of negative volatility. Once losses get to that level you have to close it out and take that loss, no losses ever bigger than that. A rigid stop loss. This is Part I of your risk management method. You must have it in one form or other.

Part II involves thinking about how the size of that maximum loss relates to your overall account. If it means 50% of your account just disappeared you are in big trouble for three good reasons:
- take a second successive loss of that size and you are out of the game. Finished.
- you need to double the depleted account just to get back to your starting point. That is a big ask.
- your emotional balance isn’t likely very balanced after a loss that size. Your next decision may not be a good one.

You are trading way too big. Your position size decision (from above, one of only the three decisions you need to make in trading) is very bad. Fix it. Trade smaller, a lot smaller. Ensure when you take that maximum tolerable negative volatility loss at your rigid stop that it only equates to a tiny % of your account. This means you can absorb many losses and still realistically recover, and it means you stay emotionally on the level and can function properly with discipline and consistency.

So, it turns out effective practical risk management just has two simple components:
I) Always have a stop loss
II) Size the trade so the loss at the stop is a small % of your account

Notice you can’t do II) if I) is not first in place. You need both elements.
And also notice none of this is intellectually taxing. Still no rocket science, just discipline and consistency of action.

So, there you have it all now: what risk is, why it is critically important to manage it well, and a simple method how to achieve this worthy goal. I hope you found it interesting and helpful at least some part along the way.

I’ll finish next post with a few comments for interest and comparison how big institutions go about the same task.
  • Post #26
  • Quote
  • Edited at 6:07pm Sep 30, 2021 5:55pm | Edited at 6:07pm
Bonus: What the Big Boys Do

As I am sure you all know, big boys play with big toys. Big investing institutions look after big money and so throw big resources at managing risk, at a level retail traders can’t even dream about. Quite literally, they look at their business as one huge exercise in controlling risk, not returns.

Their investing holy grail is capturing 100% of all the theoretically available returns made available by assuming any given degree of risk. If they assume more risk in their investments you can be sure they will demand a higher achieved return. If not, the responsible investment professional will shortly be seeking a new position.

They have created and use a veritable mountain of very rigorously analysed investment theory to guide their processes. Simplistically put, the investment decision seeks to position their portfolios on an ‘efficient frontier’ where the mix of assets will squeeze out the maximum returns for the risk taken, on the basis of past historical volatilities for each asset. Of course, just like us poor retail traders, they don’t have to be right and reality may well deviate from the historical models. But they will observe, analyse, learn and adjust accordingly.

They also have a very thorough statistical grasp of exactly what risk they are taking. They will further stress test analyse what will happen to them if reality does indeed turn out different from their guiding model. They are looking at the risk to their risk, if you will. It is all pretty sophisticated and their processes and controls are full and thorough indeed. They are not shooting from the hip on a gut feeling. They may not be right at the end of the day but it won’t be for lack of effort or analysis.

I hope you can see it is a long way from a humble retail trader putting on their comparatively ridiculously microscopic trade just because they saw their rather basic setup occur. But it doesn’t prevent the trader from acting in a professional manner, and they can use simple tools and processes to just as effectively manage their risk as the big boys do theirs. Sure, it’s comparing a microbe to a galaxy but it doesn’t in itself mean the microbe can’t survive equally as comfortably in its own single cell way. The game is played rather differently at different size levels but it’s still the same basic game in the end.
Quoting Oldtraderman
Bonus: What the Big Boys Do As I am sure you all know, big boys play with big toys. Big investing institutions look after big money and so throw big resources at managing risk, at a level retail traders can’t even dream about. Quite literally, they look at their business as one huge exercise in controlling risk, not returns. Their investing holy grail is capturing 100% of all the theoretically available returns made available by assuming any given degree of risk. If they assume more risk in their investments you can be sure they will demand a higher...
They likely hedge, and have more than enough money to handle the DD. The average retail trader (that's most of us) can't do this. And I strongly suspect they use highly sophisticated algos (bots).
You don't know because you don't ask.
Quoting here2there
{quote} They likely hedge, and have more than enough money to handle the DD. The average retail trader (that's most of us) can't do this. And I strongly suspect they use highly sophisticated algos (bots).
I think they may play latency arbitrage a lot for example.

something we indefinably cant do on a consistent basis nor have the capital for the research it takes to get ti done on different types of markets even outside of FX

all i can expect of the market is for it to meet its ATR most of the time. i dont know why it does but i know it usually gets close give or take. 30 day ATR seems to be the most accurate vs the default 14 day.
Hi Oldtraderman,
Regarding risk and risk management, if I'm being correct you've mentioned earlier that even if the worst possible thing happened in the world in the next minute, your trading accounts would still just be fine. Could you give more details on why have you come to that belief?
Quoting here2there
{quote} They likely hedge, and have more than enough money to handle the DD. The average retail trader (that's most of us) can't do this. And I strongly suspect they use highly sophisticated algos (bots).
Hi here2there,
Many thanks for your comments. Yes, they definitely hedge their positions in various ways as and when it suits their needs.

Though they can of course withstand significant DD they actually try pretty hard to avoid deep DD because the vast bulk of their money is client money and clients quickly start getting very nervous when the red ink begins to flow. The strategies big institutions typically follow tend to be relatively risk averse conservative ones to help avoid this problem in the first place.

The use of algos is indeed widespread but typically more so on the market making side of things for institutions who engage in that kind of activity.
  • Post #31
  • Quote
  • Edited at 4:19am Oct 1, 2021 3:00am | Edited at 4:19am
Quoting hazelj80
{quote} I think they may play latency arbitrage a lot for example. something we indefinably cant do on a consistent basis nor have the capital for the research it takes to get ti done on different types of markets even outside of FX all i can expect of the market is for it to meet its ATR most of the time. i dont know why it does but i know it usually gets close give or take. 30 day ATR seems to be the most accurate vs the default 14 day.
Hi hazelj80,
And many thanks for for your comments also. Latency arbitrage is a niche of high frequency trading and takes a high degree of specialism to engage in properly; very much a hard core trading firm strategy rather than typical institutional behaviour.

Your ATR observations are interesting. I would agree it is a simple and not bad indicator of typical market volatility. It is a useful starting guide to think about how far away to put stops and targets in any given market/time frame combination. You don't want to be knocked out by random noise but equally you don't want to risk more points than you reasonably need to. ATR helps to give a handle on this
Quoting diamond1011
Hi Oldtraderman, Regarding risk and risk management, if I'm being correct you've mentioned earlier that even if the worst possible thing happened in the world in the next minute, your trading accounts would still just be fine. Could you give more details on why have you come to that belief?
Because it not really important what happens in the market because the Truth is the market is random
( Why random because it movement is decided by big players)
So the only thing matters is risk management
With a working strategy and a mindset
Every trade you take you can't know it outcomes for sure
Trading is a business
  • Post #33
  • Quote
  • Edited at 5:02am Oct 1, 2021 3:10am | Edited at 5:02am
Quoting diamond1011
Hi Oldtraderman, Regarding risk and risk management, if I'm being correct you've mentioned earlier that even if the worst possible thing happened in the world in the next minute, your trading accounts would still just be fine. Could you give more details on why have you come to that belief?
Hi diamond1011,
Yes, have to plead guilty to that also. But it's not just a belief, it's closer to a certainty: I only risk 1% of my account on any trade, I only have one trade open at any time, my stop loss orders are firm and always resting in the market, I don't hold positions overnight, I only trade active, liquid markets where my size is completely insignificant, and I trade through a firm in whom I have some trust they deal efficiently and fairly. So the worst that can happen to me is a 1% loss + slippage. Even if the slippage was truly enormous I'm not going to be losing more than, say, 5% of my account. I'm going to be fine whatever happens.
Hope that explains OK
Quoting djahidait
{quote} Because it not really important what happens in the market because the Truth is the market is random ( Why random because it movement is decided by big players) So the only thing matters is risk management With a working strategy and a mindset Every trade you take you can't know it outcomes for sure
Hi djahidait,
With all due respect I can't really agree with some of your comments here.

The market is demonstrably not random; unpredictable and chaotic would be more accurate. Think of the market somewhat like the UK weather, it's certainly not random - each year summers are reliably warmer than winters for example - but it is very unpredictable day to day.

Equally, market movements are not wholly dictated by the big players. In any active, liquid market the volume of business is way too big for a big player to routinely influence. Sure, they may be able to temporarily affect the market with their actions but they can't control it like a puppet on a string, the market is too big even for the biggest of them.

You are, however, very correct in stating that risk management is what matters because you can never know a trade outcome for sure. 100% right. And because you can never know for sure you have to manage that risk, any trade can be the big bad one that wipes you out unless you control the risk. You just have to think that way to survive over the long haul.
Hi OTM,

thanks for taking the time to offer up your wisdom, its been a great read. I have a couple of questions.

Do you structure your trading plan/edge predominantly around a large risk to reward ratio?, do you think that this is essential to succeed long term? I have noted that some of the more experienced writers on here look for a minimum of 1:3 - 1:6 etc.

In your experience, do you feel that "successful" traders have a "unique" type of edge or view of the market that enables them to profit more than most? (they see things others cant)

finally: If you were to mentor someone, would you coach them on a vanilla type of strategy (like 'trading made simple') and then encourage them to be more creative and look to develop something superior?

cheers
life is a reflection of what we allow ourselves to see
Quoting mikeeating
Hi OTM, thanks for taking the time to offer up your wisdom, its been a great read. I have a couple of questions. Do you structure your trading plan/edge predominantly around a large risk to reward ratio?, do you think that this is essential to succeed long term? I have noted that some of the more experienced writers on here look for a minimum of 1:3 - 1:6 etc. In your experience, do you feel that "successful" traders have a "unique" type of edge or view of the market that enables them to profit more than most? (they see things others cant) finally:...
Hi mikeeating,
Thank you for you kind comments. Your questions are excellent, let me deal with them in turn:

No, I don't routinely look for big RR trades. My base trading strategy is to play for 1:1 RR trades and try to get more winners than losers over time. If I'm lucky and braver than usual, I'll sometimes let a winner run on for extra windfall profits but it's not the norm for me. Why I do this is more a function of my psyche than anything else - I am terrible at running winners, I always want to ring the cash register. Rather than fight myself I work with it and employ a strategy that suits me, even if it is strictly not optimal. Otherwise my stress levels would be too high and I wouldn't be able to stick with it consistently as you must.

No again, big RR is not essential to success, positive expectancy and the discipline to trade consistently is. A risk:reward of 1:2 means you need a 33% success rate to break even, better than that you have positive expectancy. Turn it around to 2:1 and you need better than 66% success for positive expectancy. It's a spectrum and you choose where to play, I play at 1:1 for example. Anywhere on the spectrum can work, profitable scalpers and long term trend followers both exist and they operate at different ends of the RR spectrum. Equally, anywhere on the spectrum can fail miserably, it depends on your makeup, how you see a market opportunity, and how well you then trade.

No a third time, in general I don't think consistently profitable traders have any special gift of unique market view. They see what less profitable traders see, they just handle it better. People mostly fail at trading through lack of a defined, positive expectancy plan that suits them and/or poor trading habits, the single biggest one I think being lack of discipline to control and mitigate losses. Good traders just trade better than the rest of us, not because they have an innate gift.

Finally, if I were to coach someone (I never have) of course I would start them out on something really simple, just so they got the experience of how markets operate and what they can do to your trades. From there it would be a matter of working out what style of trading suits them and develop something sensible for them to use, not necessarily any more complex. Some of us are born to be very active short term scalpers, others more kick back with a coffee and ride that long term trend. Viable strategies can be developed for both and all places inbetween, but if it doesn't suit you emotionally and psychologically, it's really not got a hope.

Hope that helps
Quoting Oldtraderman
{quote} Hi mikeeating, Thank you for you kind comments. Your questions are excellent, let me deal with them in turn: No, I don't routinely look for big RR trades. My base trading strategy is to play for 1:1 RR trades and try to get more winners than losers over time. If I'm lucky and braver than usual, I'll sometimes let a winner run on for extra windfall profits but it's not the norm for me. Why I do this is more a function of my psyche than anything else - I am terrible at running winners, I always want to ring the cash register. Rather than fight...
Thanks for your reply mate, always so much to learn!
life is a reflection of what we allow ourselves to see
Quoting Oldtraderman
{quote} Hi djahidait, With all due respect I can't really agree with some of your comments here. The market is demonstrably not random; unpredictable and chaotic would be more accurate. Think of the market somewhat like the UK weather, it's certainly not random - each year summers are reliably warmer than winters for example - but it is very unpredictable day to day. Equally, market movements are not wholly dictated by the big players. In any active, liquid market the volume of business is way too big for a big player to routinely influence. Sure,...
80% with you,

But my opinion still think the market is random like 85% of the time it is random,
it like flipping a coin there is no sure outcome.

But also it depends on the timeframe like shorter ones are harder to predict..
Trading is a business
Quoting Oldtraderman
{quote} Hi hazelj80, And many thanks for for your comments also. Latency arbitrage is a niche of high frequency trading and takes a high degree of specialism to engage in properly; very much a hard core trading firm strategy rather than typical institutional behaviour. Your ATR observations are interesting. I would agree it is a simple and not bad indicator of typical market volatility. It is a useful starting guide to think about how far away to put stops and targets in any given market/time frame combination. You don't want to be knocked out by...
Thanks I have observed a lot of indicators but range/volatility remains to be one of the most useful tools for trading markets. That's the only thing I know that changes. Market volatility. When people say markets change that's all I think about. I mean 10 years ago pairs were moving 150-250 pips a day. Some of those same pairs don't even move 60 pips now

Different times indeed
Quoting djahidait
{quote} 80% with you, But my opinion still think the market is random like 85% of the time it is random, it like flipping a coin there is no sure outcome. But also it depends on the timeframe like shorter ones are harder to predict..
Daytrading suits me the best, I have no positions open at the end of a long day, I know I wont be woken up by rude shocks, but I just can’t believe the mettle of scalpers. Takes a lot to enter and exit in a fraction of minutes. Hats off to those who trade M1 charts!
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