Risk Management Principles
Risk management is a paradigm. A mindset.
Remember it is always about what it costs you. Your financials and your peace.
Beware of 2 axioms: “Let Your Winners Run” and “Buy the Dip”
It is always about what you keep. Your net.
1. What is “total open risk”?
Scale in and out – I am a scaler!!! In bull and bear markets! It is my style.
Know your time frames. Avoid turning day trades into long term holdings. That goes against your trading plan! Establish your time frame before you enter trade and stick to it.
Reduced position sizing
Follow your trade plan. Establish trading plan BEFORE trade to minimize emotions during trade.
Stops – pivot points & supports on MA. EMA or SMA plus my own position stops. Options are different. They swing much more.
Relative strength, sectors with strength and choosing leaders
Getting good entries & managing risk/trade
Always use Risk Adjusted Return – potential profit from investment considering the risk to achieve it.
Risk is assessed vs risk-free investment (treasuries) often using treasury bonds as a proxy for risk-free rate of return. Portfolio/investment rate of return – risk free rate.
The times have changed now with rising rates, and we are able to receive more of a real return on risk-free assets. In 2020 (April) – early 2022 (June) time period, treasury real yield curve rates were negative. Now they are positive again, so the risk tolerance has changed. Risk is recalibrated based on this so the risk adj returns are lower.
Sharpe Ratio = (Rp − Rf) / σp, where Rp = return of portfolio, Rf = risk-free rate, σp = standard deviation of the portfolio’s excess return
ERP are important too. Equity risk premium is the difference between returns on equity/individual stock and the risk-free rate of return
As risk-free rates rise so does the spread, therefore SPX returns must be higher thus valuations and price must come down.
ALPHA – risk adjusted performance of a security vs market ave
I do not prefer a set % for a stop loss rather use that stock’s specific support levels such as Moving Averages (9, 21, 50, 100, 200) or pivot points.
I sometimes make quick exits especially in a bear market like 2022. I will place stop on low of day after I enter so I can quickly exit if it goes against me. I do not hold and wait and hope for it to come back.
Sizing of position: standard for some – 50% at risk. In this whipsaw market, 25% and when stronger market with more consistency then could be as high as 75% and even use leverage such as margin plus naked options. It depends on overall market.
Always trade with stops and set before entering trade.
2. What factors help you determine when to be aggressive and when to be defensive?
Progressive exposure
Scaling in slowly to assess. Keep it small and then can add more or take a small loss if it goes against us.
Always remember it is about what it costs you! Financially and mentally!
It is about what you keep. Your net.
Being aware of overall market and use portfolios as feedback for performance.
Look at overall macro landscape and FED. FED affects market directly. Liquidity and rates are very telling of direction of market. They fuel the market one way or other.
Look closely at sectors, indexes. Breadth, trend related to MAs, strength, etc
3. When do you step back entirely and take a break and trade less?
Market awareness
Self-awareness – Knowing yourself and what works for you. It is about your strengths and weaknesses
Reducing length of feedback loops
Focus on my portfolio. 2022 has been a “selective stock” market. What is my portfolio telling me?
Stay consistent
I have been doing less – BMR. Tight vs loose price action. 50% cash
Separate intuition from emotion
Acknowledge when your plans aren’t working. Be accountable! Better to admit you are wrong than lose money. Step back and reassess what you are doing wrong. For me, I need to remove myself, clear mind (meditate or work out) and then return.
Mindset is everything. If you are upset from loss or too elated from win. Take a break too!
4. What changes/adjustments, if any, have you made in the current environment?
Reduced position sizing is a must for me. Much higher cash positioning with on average about 45-55% and always balancing it.
I don’t usually buy breakouts in bear like a bull market. They are usually fake outs. Very cautious.
Buying breakouts in bear leads to bad entry usually especially with whip saw market. Don’t chase.
Doing less overall.
With Higher VIX (throughout this year) also higher IV, doing more spreads to help reduce risk and lower cost basis. Prefer selling options always but especially in higher IV environment to reap benefits.
Rarely buy long calls but since in downward trend I have purchased long puts which I don’t really do in bull markets. More long puts>long calls.
Take profits when I see them and don’t “let winners run” as they can quickly turn green to red.
Do not “buy the dip”
5. Do you use leverage or avoid it? Do you hedge against your position?
Options trading for risk management – I will keep it simple here.
Sell Covered Calls against position – slightly bearish depending on strike
delta <.2 or .3 depending on stock, premium amount and time period ($/time) and/or price I don’t mind selling at and can always adjust ie roll out and up – forward and back. (higher IV)
time period within 2 mo.
delta = % ITM at exp
Buy protective puts.
Collar – CC and buy put (lower IV) or expecting more downside
Buy index or sector puts or inverse calls SQQQ SPXS or TECS/TECL
I prefer CASH as a hedge.
CC can be forgiving in a bear market as the market pulls back and they can expire worthless.
6. What are your “expectations”? Reality based expectations are central to risk management as well as “expectation alignment”.
Have a goal for each trade that is aligned in terms of time frame and expected gains.
I use Cost benefit Analysis with everything in life – with business decisions and trades. We must assess our downside risk BEFORE taking a trade to decide if it is worth it and help establish our exit plan BEFORE we enter.
Cost Benefit analysis – I assess the risk and potential cost for the potential gain or benefit I can receive. I also assign weights to each. So, let’s say I have a higher probability of winning over losing but the win amount is lower than the potential loss, then I may still take it. Alternatively, if in a trade the loss is very low (with higher probability of occurring) against potential for a high win amount (with lower probability), then I may also still take it. They can balance each other out.
Ignore the noise and other people. They are the ones usually fueling the “fantasy”! Ignore their “gain porn” that can lead to you feeling FOMO, increasing your risk and greater probability of losing!
Difference between skills vs execution. Just because you have the knowledge does not mean you always execute well.
Average winners vs average losers (it is about the total weight of each)
In this market, breaking even is a triumph. So then, is all this work worth your time for break even? You are essentially getting no pay for work? Think about it.
Avoid overtrading.
Does your feedback match your expectations?
7. How do you reduce emotional trading (Reduce as we cannot eliminate. we are human)?
Use your emotions in a positive way. Channel them. Your passion will drive you.
Reduced position sizing reduces risk and emotions tied to trade
Separate intuition from emotion
Know yourself and learn to identify the emotion. Takes time and practice but you will know when you “feel” driven by emotion vs “feel” intuition. Remember in decision making (one of my fields of study and expertise – DIS) with experience you make “expertise based intuitive decisions. Many chess players and traders speak about just “feeling” it. It happens. However, that does NOT mean you are emotional. That is intuition.
Always establish a trading plan BEFORE you enter your trade. Then follow it whether or not you want to during the trade because once in the trade you have more emotions tied to it and you cannot trust yourself. So let’s say you sell a stock once it hits your stop loss and then it bounces to new highs. Oh well. Because it is this trading plan that will save you when it really matters. Better to be cautious and preserve capital than get upset about missing out.
No FOMO and FOLO.
Do not chase. How do you know? Is it over extended or breaking out? We decide when stocks are overextended and due for a pullback and be rational about it. Patience. And if you miss it, so be it. Better to miss than bag hold.
Avoid impulse trading – Delayed gratification and patience.
Don’t rush. Mistakes increase when rushing. If you miss, so be it. Plenty of other fish in sea.
Don’t get too down about this “tough market” as after every challenge comes more opportunities. Stay positive.