Risk Mgm

A discussion on risk management.

Trend-Following
Imagine each unit of market price movement as an impulse - long impulse or short impulse. When you buy on a long impulse and there is a trend, another long impulse will appear and you raise stop accordingly (trailing stop). If there is no trend a short impulse will appear and hit your stop, you sell. In a few big trends you make huge profits, to cover small frequent losses and more, ie trend-following.

Gambler's Fallacy
At the casino, after a string of heads is tossed, what is the odds of a tail the next toss? Common sense let us think there is high chance of a tail because so many heads in a row is rare. That's not true and can be proven mathematically. The next toss is still 50/50 for a fair coin. The analogous context in stocks is if a stock keep dropping a lot, it does not mean its time for a rally.

Sunken Cost Effect
When a trader is at net loss, he will often take more risks than he would if he is at net gain. Because he has lost that much to market, he expect to make back that much from market. However, such mentality induces high-risk actions which backfire his original intention. The wrong mindset will make him continue to lose more.

Prospect Theory
Human are likely to take riskier actions in losing positions than in winning positions. Amateur traders like to cut profits short and let losses run. They are "scared" to let profits run away but "hope" that losses can become gains, contrary of probability. Recognise these emotions when it happens to you. Act on logic, not on emotions.

Babe Ruth Effect
The classic case for portfolio managers. Everyone in the team had net many winners and few losers but all made a net loss. Except one guy who has a small number of winners while most are losers. He made a net profit instead. How come? He cut losses short and let profits run. To survive longterm, keep taking lots of small losses.

Kelly Formula
Define the optimal risk ratio to maximize gains in shortest time. Kelly Ratio = win/loss ratio - [(1 - win/loss ratio)/(average gain/average loss)]. For eg, you can use 1/4 of Kelly Ratio to take a slower approach and hence lower drawdown. This is important. "Optimal" ratios can create big drawdowns which is psychologically unbearable to last until turnaround.

Two-Six Rule
This method from Alexander Elder protects a trader in two ways. Not risking more than 2% of trading capital on any single trade protects a trader from a big single loss (shark bite). Not risking more than 6% of trading capital in one month protects a trader from a series of small losses that hurts (piranha bites). If a trader lost more than 6%, his capital will stay outside market for rest of month.