Measuring and Monitoring Risk

The proprietary traders who work at MBF fall into one of two categories: They are either discretionary traders or they are traders who develop black-box systems. The systems group is far easier to manage. Each trade requires a particular setup and has specific risk-reward criteria. Furthermore, each system portfolio has individual position stops, as well as the portfolio having an overall dollar risk limit. The discretionary group presents a far greater challenge to manage, since we are now dealing more with trading personalities than trading positions.

Floor traders in the various energy and metal trading pits along with off-floor, short-term, seat-of-the-pants traders make up this discretionary group. To them, long term is never more than a few trading hours. Short term may be as little as five seconds. Our job is to help these traders find their own comfort level. One trader may have the psychological makeup and discipline to trade 50 or 100 contracts at a clip, in let's say, natural gas. While another may feel more comfortable trading spreads.

We set each trader's position limits based on three different types of trade scenarios.

1. Is it a trade that will be initiated and liquidated within a matter of seconds, "a scalp trade," or will it be longer term?

2. Is it a spread or outright trade?

3. Is it a trade that will be closed out by the end of the day or it will it be a position held overnight?

Obviously, a trader who scalps the market with 100 lots at a time probably has the same risk profile as someone who trades one-third of this size but keeps the position on for 10 to 15 minutes. Furthermore, a 50-lot trader in let's say, natural gas, fits a different risk profile than a 50-lot trader in crude oil, just as someone who trades 3,000 IBM at a clip takes a different level of risk than someone who trades 3,000 Yahoo.

In the appendix are exhibits of the daily pivot sheets for both stock and commodities. The column labeled $ risk is a proprietary measure of the inherent risk across all futures contracts and all stocks. Ten S&P contracts have a lot more risk than 10 natural gas contracts, which have a lot more risk than 10 Comex Gold contracts. For example, this $ risk measurement tells us how many natural gas contracts to trade for every one S&P contract. If the S&Ps have a daily risk of 6,000 while natural gas has a risk of only 1,000, for each S&P contract that you put on, you would have to trade six natural gas contracts in order to get the same risk equivalent position.

No matter how large or small the trader is, MBF follows the same risk guidelines. Since most traders have type A personalities and are goal oriented and very competitive, we provide incentive to them by allowing them to trade on a bigger scale if they meet certain intramonth profitability levels. This is our way of letting a trader who is on a hot streak step on the gas. We are trying to allow this trader who is in the groove to go for doubles and triples, not just singles. Conversely, if a trader is going through a slump, we will cut his position size. Sometimes as little as a one-third, or as much as a one-half or even two-thirds, to prevent this slump from becoming a black hole from which he can never recover. Remember, those who survive their bad runs are the ones who are successful in the end.

At the end of each month, whether a trader has had his position size increased or decreased throughout the month, we erase the blackboard and start the following month at his original position limits. The rationale being that the trader who has been on a roll is eventually going to cool off and we want to bring him back to his normal size before he gives back a significant amount of his profits to the market. On the other hand, the rationale for the trader who has been in a slump is that if you believe that nothing has fundamentally changed in this person's trading ability, forcing him to remain at minimal position levels for too long will make it almost impossible for him to recoup his losses and return to profitability.

Lastly, we encourage our traders to trade bigger when the markets are busier and volatile. This is exactly when a floor trader or a short-term trader can best capitalize on their trading edge. However, most traders do the exact opposite. Out of fear they decrease their size when the markets are volatile and increase their size when the markets are dead.

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