Risk Management in trading systems

One of my first memories of learning market mechanics was a cover article of an issue of “Technical Analysis of Stocks and Commodities” that detailed some aspects of risk. I had never explored the subject, and was surprised by what was entailed. It was a typical instance of “you don’t know what you don’t know.”

I saved that issue of the magazine for many years. Unfortunately it was tossed somewhere along the way. But while reading that article I began to think about how software could help the retail trader. If a spreadsheet could take in the necessary information, the user could see where adjustments may need to be made to match their risk profile.

Thinking back at such a naive thought causes nostalgia. Those that know they need it have built it, those that do not know will either flame out or learn.

I recently purchased several audio books in the Jack Schwager series. I’ve read many of them, but it is nice to have them in audio form and listen passively. Certain nuggets stand out. In his hedge fund series of interviews, he goes back in history to the origins of the true “hedged fund”. From that it becomes clear that a risk management strategy is the core to generating alpha over the long haul. Studying additional materials on those first forays into “group investing” you see that it took a long time to catch on, but is a pillar of just about everything on Wall Street.

But how much of that trickles down into the typical trading systems I am asked to build? Unfortunately, very little. Most are concerned with concentrated “bets” on the short-term direction of a security. Getting the entry and exit right and following the rules is certainly a big part of the equation. But ignoring the “bigger picture” items such as risk management is often the cause of big losses.

So what can I, the lowly software guy do? While I can sometimes draw their attention to the issue at the outset, often it comes down to reporting. After running a back test, provide some statistical references to a broader index, or VAR, or what the market was doing while the simulation was running. Those are small numbers that open the door to bigger discussions on what markets best match a particular strategy.

This is a deep subject. Perhaps I should break it down into smaller sections by risk type to organize it better.

Please note: I am not pretending to be an expert here. I am simply writing down what I know for my own benefit. If you want to chime in, by all means, please do!

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