Know Your Risk and P/L Management

 

By AskBrokers.com

Risk is a complex area and much has been written on the topic. Simplified I would like to say that risk is the volatility of returns.

See below two portfolios; Portfolio A has boring returns where the trader makes 5% per year. The second portfolio (B) is more dynamic with much higher returns per year, except for one year where the portfolio decreases by 40%. This one big drawdown offsets all other good years in a way so that the total of Portfolio B is actually lower than Portfolio A after 8 years. This shows the importance of limiting your trading from big drawdowns.

The below table is self explanatory and takes us back to the argument of limiting the downside to our portfolio.

You must have the relevant tools in place on order to manage risk and p/l of your portfolio because volatility is risk!

Risk management is a vital part of successful trading! Most people realize this but very few understand what risk is, nor do they have the tools to properly manage the risk in their portfolio. You will read about stop losses and other risk management tools on sites written by so called traders that actually lack proper understanding of risk and p/l management.

There are many ways to calculate the risk in your portfolio, but most of those are formulas not easily understood, one example is VaR (value at risk).

Risk must be understood easily and the tool(s) must be easily managed!

A trader produces only one thing, p/l. Therefore it is vital to manage and optimize the p/l. While most risk management systems focus on the risk via various formulas, I believe, especially for relatively short term trading, one should manage risk in relation how the underlying p/l of the portfolio is developing.

The actual p/l produced should determine what risk you should be taking.

The more money you are generating the more risk you should take. Inversely, the more negative your p/l is developing the faster you need to reduce risk taken.

 

The must read in depth version on Risk and p/l management can be read here