Q&A
Since You Asked
Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Monitoring risk
First off, I want to say that I have been reading your Stocks & Commodities column and blogs for years. With all the bad information and negativity out there, I applaud you for your willingness to share, your frankness, and especially keeping your cool under fire at times.
Now, I have a couple questions about risk management, both from a trader’s perspective and a trading firm’s perspective. First, as a retail trader with a $50,000 account and sometimes using Pdt margin of four times equity, I have written a program that places stop-loss orders at 1% of my equity for all my trades. But I seem to get hit too often and then see the market reverse over the next time frame. How would you handle this situation?
Second, I’m thinking about joining a prop trading firm, but I am concerned about possible losses due to using leverage. How does your firm monitor risk on all your traders? Do many of your traders blow up accounts when things happen like the May 6th 1,000-plus point move in the market? I realize that day was extreme, but any light you can shed would really be appreciated.
— Optimizer
Wow! First, thank you for the extremely kind words, always appreciated. The negativity you refer to are generally brought on by the minority of the wannabe traders out there looking for a free ride. That does not happen in this business.
Now to your questions. Risk management as defined by investopedia.com is a two-step process — determining what risks exist in an investment and then handling them in a way best suited to your investment objectives.
We all look at risk differently. In your scenario of a 1% stop-loss order on all your trades, I see extreme risk — not in the stop-loss amount, but by using the stop-loss itself. If you are an active-enough trader to be able to sit in front of a computer most of the trading day, then I would suggest that you think about using nonlethal alerts vs. actual stop orders. This way, you can take a second to evaluate the overall market conditions, time of day, who’s on TV yakking about who knows what — anything that might affect the next few minutes of trading. Hard stops seem to act like magnets prior to price reversals in many cases. Perhaps use hard (partial) stops if you cannot monitor your trades in a timely manner.
The actual percentage to use with alerts or stops should vary depending on beta of individual stocks and/or if you’re trading hedged instruments or pairs. I suggest tighter trading with naked directional trades, but perhaps only for half shares. If the price reverses, then you’re happy you only exited half your shares. And if it keeps going against you, then you’re happy you covered at least half.
Now, as to how we monitor risk in our firm (each firm is different, of course) — Goldman Sachs, our clearing firm, provides us with risk control programs that we can set in various ways. We set our primary computer to monitor for any trader’s account that might be down 10% or up 25%. We may have a handful pop up on any given day. We have several sets of eyes and multiple locations to view the overall risk. If we see a trader pop up, we pull high the account and check for all open positions. We ascertain where the losses came from, even if from closed positions, and decide if the trader has already covered the risk. If we see continuing risk, we contact that traders’ managers or the traders. We discuss what is going on and do our best to protect the traders from themselves. We rarely have to call more than two or three traders in any given month (out of several hundred), since our people tend to be pretty serious about their careers.
Now, as for the wild ride on May 6, 2010. We had fewer than 10 “concerns” — no six-figure losses, and we survived basically unscathed. Not only that, I think a few traders have learned more about how to manage their own risk. Hope this helps.