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PTMC team 23.07 2015

Risk Management in Protrader part 2

Hey there, Protraders!

In the previous article dedicated to the risk management, we have given a general definition of risk, have considered its main types, as well as touched on the risk management methods. In this article we’ll consider the practical side of risk management. We’ll show how you can manage a portfolio, simulate and assess future risks while adding new assets using the trading platform Protrader.

Formation of the investment portfolio is very laborious process, in respect to the correctness of the instrument selection, their volume, level of risk, etc. At the first stage, purpose of the investment and time horizons of holding the portfolio are determined, as well as an attitude of the trader or investor to the risk (the degree of tolerance). At the second stage, it is important to create a balance of the portfolio by the ratio profit/risk. At the third stage, we solve a question of the diversification by assets, in terms of their trading features (volatility, liquidity).

Risk Management in Protrader

First of all, let's open several positions and create some portfolio. In the Positions panel, we can see the list of our symbols, their volume, side and current P/L level. If necessary, you can configure this panel and allow displaying additional parameters, such as Stop loss, Take profit, exchange fees, expiration dates, and others. The information about margin used, the level of risk and the availability of funds for opening new positions has been immediately updated in the Account details panel.

Positions panel in Protrader

Risk management of a single position

As you know, amateurs are always looking for entry techniques, and professionals are thinking about how correctly to exit from the position. Therefore, if talk about the risk management of a single position, then an important element is the Stop order. Often, traders place Stop orders based on the profit/loss ratio, 2:1 or 3:1. Such approach is not entirely correct, because stop order has an exclusively emergency nature and must be triggered, when a trading advantage is not on your side. Therefore, stop orders should be adapted to each trading strategy, instrument and timeframe.

For example, the ratio with large stop loss and small take profit is often used. Therefore, the trader gets much more trades with a small profit, and rare losses, but with larger size. Usually such a tactic is used during the overnight trading, when the market volatility is low and there is a high probability to stay in range. We've described the similar strategy in our previous article dedicated to technical analysis.

Sale of the options can be considered as another example of trading with a large Stop loss. Such a tactic is very popular among beginners: selling the options far out of the money, they get a small profit (as a premium), and hope that the price will not reach these strikes. When the price reaches their strikes, the option cost is increased by several times (10-20 times or more). The profile of the sold option shows the dependence of the option cost from the underlier price.

Trading with a large Stop loss

Some traders use other types of stop orders, such as Trailing stop, time-stop or reversal stop order. For example, if during the four days after entering the long position, the close price could not exceed the entry price then position will be liquidated. Example of a Trailing stop order is shown on the picture below.

Trailing stop order

As we already know, the functionality of Protrader platform allows trading different instruments (exchange and off-exchange). Therefore, the need to simulate and optimize the portfolios occurs during the work of the portfolio managers. What does the simulation of an investment portfolio mean? On practice, the task of the manager is to preserve the high efficiency of the portfolio, with a minimum level of risk. Hence, to resolve such a task different approaches are used.

  • First of all this is a probabilistic approach, which assesses the possibility of a negative scenario (losses) simultaneously on all elements of the portfolio.
  • The second approach - is the diversification by trading instruments - takes into account the volatility of each element in the portfolio, their liquidity, correlation between itself and the individual features (trading hours, the number of market makers, margin requirements).

The curve of the optimal portfolio depending on the risk and return is shown on the picture below.

The curve of the optimal portfolio depending on the risk and return

Margin Analyzer panel allows calculating the risk level and the volume of the margin requirements while adding new instruments to the portfolio. For example, let’s add several new positions to the previously created portfolio and click "Analyze". In the column "Impact on portfolio", we will see how our parameters will be changed if we really add these positions. Herewith, in the column "After trade portfolio", all portfolio characteristics will change automatically based on the current and estimated portfolio.

 Margin Analyzer panel in Protrader

Instruments added to the portfolio should be selected according to the trading system, taking into account the individual characteristics of each asset. Herewith, the position volume is set based on:

  1. profitability expectations by the instrument;
  2. the degree of risk (the higher the stop level, the higher the risk);
  3. and margin requirements.

Profitability expectations by the instrument, the degree of risk, margin requirements

The optimal portfolio should contain different asset classes (stocks, bonds, commodity futures, currencies), but not just instruments of one group (for example, only currencies or stocks of one sector). As an example, the optimal portfolio can be created in the following proportions:

  1. 20% US stocks;
  2. 20% foreign stocks;
  3. 20% commodity futures;
  4. 10% currencies;
  5. 30% 10-year US bonds.

Herewith, an important element of the portfolio management is rebalancing. Suppose that the US stocks increased on 15%, while the cost of other assets stayed virtually unchanged. Hence, it is necessary to reduce the US stock positions and to align the portfolio ratio. Such portfolio balancing allows saving the level of risk and volatility of the portfolio relatively constant.

Another example of the portfolio recalculation is its protection from falling using the options. With the growth of the US stocks prices on the same 15%, we have no need to close the long positions, we can just align the proportion through the purchase of put options. Such approach allows keeping the possibility of further growth of the stocks, herewith in the case of price reduction, our option will compensate the decline in profits.

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