TheRiskBlog

There is quite a bit math involved with risk management. To be on the safe side we have to cope with ratios, P&L equations, risk engines, no trade zones, beta, volatility and so on. Most of this stuff is straight forward though and can be done with only a little knowledge of the formulas behind it. But here is an article about something that has not yet found its way into risk management.

That’s what a friend of mine recently responded when I asked him about how much of his money he wanted to risk in his stocks.

Not long ago, this friend of mine had read an article about a company which was considered to be a good stock by an economic journalist. And having available some money in his account, my friend thought about buying some stock in this company and holding it in the long term. But before he did this, he came to me asking if this was a good investment. He thought, that with me being a trader, I could help him to make this decision. He expected to hear from me, whether this company and its products were successful. But that’s usually nothing I am really concerned about in everyday trading….

I am sitting here at the bottom of the world famous “Eiger Nordwand” (Eiger North Face) in Switzerland with 5 open positions in my account.

How does that work as far as riskmanagement is concerned?

Well, given, this article is being written on an iPhone and having an iPhone available certainly helps. First of all i can check stockprices online, which is not a problem because they have UMTS available even here directly at the bottom of the Eiger.

But does it help to know the prices? No, because knowing the prices doesn’t change anything in my account. I need to be able to sell positions if the need be.

So, secondly i need to have a way of calling my broker to size down or even completely sell positions in the account. Only then having an iPhone available helps. Did i bring the number of my broker? Yes, i did and so should you. Make sure that you have the telephone number of your broker readily available, when you are on vacation with open positions.

But then again i’ll be hiking a lot today and it is not practicable to check my iPhone every 5 minutes, so i kind of need an extra method of how to cope with the risk of losing money in my account.

Here is what i did. I first checked the volatility (ATR=Average True Range) of every single stock in my account. I then made sure, that not a single volatility is higher then my total open profit in the account. This way stockprices can drop, but as long as they stay within their historical volatility the dropping prices can not hurt me.

Let´s look at an example. Let´s say we own 200 AAPL and AAPL shows a historical 14 day ATR of $4. That means that we can lose $800 in a single day since we own 200 of them and need to multiply our position by the volatility. 200 * $4 gives $800. If we have an open profit of - let´s just say - $2000 nothing would happen, because even if AAPL drops by its full historical volatility of $800 we still would have $2000 (open profit) - $800 (historical volatility and actual drop today) = $1200, so we´d still be in the green.
But if we only had $1000 of open profit, the drop of $800 would be too much for our account, since this would mean to give up 80% of our open profit, so it would be too much risk for the account. In this case i had to sell 100 AAPL before i went on vacation, just to get the risk level right.

Ok, enough written on the subject, i am on vacation and sitting here at around 5000 feet not moving i am getting cold, so i need to get up and going.