Managing Risk and Portfolio Volatility

Discussions about Money Management and Risk Control.
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jklatt
Roundtable Fellow
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Joined: Sat Feb 17, 2007 11:51 am

Managing Risk and Portfolio Volatility

Post by jklatt » Mon Mar 05, 2007 11:40 am

In another recent thread, Tim posted an interview with Charlie Wright where he says the following:

Charlie Wright: We tend to be fascinated by the entries and the exits, you know, how we get in and out of the market. This is the fun part of system development. We think that to develop a great system all we need to find the greatest entry and exit. In reality, entries and exits are probably less than half of what is required to develop a good system. In the end, there is not that much room for creativity in entries and exits. A market is a market, a trend is a trend. Our research shows that depending on your time frame, all traders get in and out at about the same place. We believe that what distinguishes an outstanding trader from the average is how they execute on the back end of their system, that is, how they manage risk and volatility of portfolio positions.

The last part, "... what distinguishes an outstanding trader from the average is how they execute on the back end of their system, that is, how they manage risk and volatility of portfolio positions." is what is of particular interest to me.

Time and time agin, I read from successful fund managers that this part of the trading system is the most important... yet I can find the least amount of information on it. I guess that really doesn't suprise me since if this area really is the "holy grail" of system design, people aren't going to reveal their methods.

So maybe some of you guys and gals are interested in sharing your thoughts and/or developing ways of implementing this?

To me, managing the risk and volatility of a portfolio consists of the following:

1) Should I take the new trade based upon my current open positions? Most systems I've designed/read about typically define a static basket of instruments and take ALL of the signals generated. I imagine that dynamically managing the risk of your portfolio would involve rejecting some of these trades if you're taking on too much heat (without regard to instrument correlation). I think the "fear" behind not doing this and/or not testing the effects of doing this is that you'll miss the next big winner and it'll significantly hinder performance. Is that a "valid" assumption?

2) If it's acceptable to take on the additional risk, how much of a position should I take based upon what I currently have in the portfolio. This would be where you manage the volatility of the portfolio based upon instrument correlation in my opinion. Do I already have positions in a few of the different currencies? If so, maybe I should take a very small position or none at all? Maybe I should take a full position in this trade and lighten up on some of my other currencies because this instrument is acting "stronger" than the others that I currently have positions in.

Anyway... this area seems to be an area that is the least understood and the least talked about, but I'm always reading that it is the most important. I'd love to generate some healthy discussion on this subject.

Jason

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