How do online traders manage risk?, Last Modified, 2022-11-23 15:18:20

8. How do online traders manage risk?

Understand the bid offer spread, and that broker platforms can present information in a way that appears to overstate the valuation of your assets / trading positions and understates your transaction costs. In other words, you cannot trust the way your brokerage presents the numbers you must make sure that you mark to market as best you can. Otherwise, you could believe that you have more liquidity than you really have.

Platforms quote mid-market prices, before transaction costs. When you try to execute a trade the price you get may not reflect the price on the ticker and costs will be deducted. You should therefore make some attempt to understand the real value your portfolio positions. Professional traders are required by accounting regulations to Mark to Market, this means valuing a position at the sell valuation and deducting the cost to sell. Remember markets are dynamic and stock prices move constantly. Most brokerages are using delayed price information, so the quoted price can be up to 20 minutes out of date. When you execute orders, make sure you take account of the execution price quoted, as this might be very different than the price you expected to buy or sell at.

If you opt for best execution rather than a fixed quoted price you could lose out because of price slippage, you might want to hedge your slippage risk by familiarising yourself with limit orders, thus if you cannot execute within a trading limit the order is cancelled. Limit orders are designed to protect traders from the downside.

Each company that is publicly traded has a risk value called a beta factor. To make money in a risk adjusted way it makes sense to consider the risk on your invested dollar. Putting money to work should involve both diversifying your positions to avoid over exposure but also a consideration of the risk adjusted return or expected risk adjusted return.

If you can earn 5% on your capital with a low level of risk, taking double the risk to earn less than double the return is a bad strategy. Traders seek Alpha. Alpha is when the return you achieve exceeds the risk you take to earn it.

Graphically this is known as the securities market line or capital markets line. Being able to graphically represent your positions on the Capital Markets Line will help you to see which positions are over exposed, it will also help you to allocate different amounts of your trading capital based on expected risk adjusted returns.

When trading a position, I typically plan the trade. This requires stock selection, based on a filtering mechanism, then capital allocation based on risk, which can be obtained using a combination of historical price analysis and projected Monti Carlo simulation.

Once I have identified a portfolio position, I feel might be a good trade, I stress test my intuition by back testing the position. Back testing is not an exact science, but it at least allows you to dummy trade the portfolio. Some people called this paper trading.

If the portfolio successfully passes the back test, I have a trading plan. Then and only then will I execute the plan and manage the position.

Building the plan will require risk adjusting each individual stock pick, to balance the portfolio risk and allocate capital based on the risk return profile of both the individual stock and the portfolio.

I won’t go into the Capital Asset Pricing Model, or CAPM, but the principle is sound, understand the capital at risk and it should help you to preserve capital.

So rather than spreading your money evenly across a basket of stocks and using generic percentage stop losses, you are tailoring each capital allocation to the unique risk profile of each stock. You do this to increase the probability that you will achieve a positive return on the trade. Doing this in practice means using some form of dynamic stop loss or sell trigger in your model.

The measures you use for volatility and risk are to some degree a personal choice and most likely based on your knowledge of financial math or Quantitative methods. Standard deviation is a good place to start. Each stock price will deviate from its mean to a greater or lesser extent, and as such your tolerance to market moves should to some degree make allowances for this.

A high beta stock with a high price standard deviation will probably be more volatile than others. The capital you are willing to allocate to such a stock will be based on your personal tolerance to risk.

You will build a formula in your model which reflects both the intrinsic volatility and risk and your personal risk preferences and you will execute trades accordingly.

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