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I am interested in firm wide risk management practices and procedures. Other than portfolio correlation, VaR-cVaR, expected short fall, liquidity risk. What are they looking at? How are the determining how much size a specific desk can trade in a given day or week? How are the doing reduce size for specific strategy?
Broker: Advantage, Trading Technologies, OptionsCity, IQ Feed
Trading: CL, NG
Posts: 1,038 since Jul 2010
Thanks Given: 1,713
Thanks Received: 3,863
Good question. The answer depends on what type of desk you're referring to of course. The usual IB desk is primarily doing agency order flow about 80% - 90% of the time. If they have a good PnL running, they can take opinionated positions to add value to PnL and obviously boost their bonus potential. PnLs have shrunk from the good old days (late 90s - early 00s). Banks are cutting down on their desks as well and a lot of the order flow is purely algorithmic. There was a certain desk in Purchase, NY run by an elite group of traders at a top IB that kicked a$$ and operated more like a hedge fund.
I think a better comparison would be to look at what a CTA/Hedge Fund is doing. Risk parameters will obviously vary but here are a few to be aware of:
1. Correlation and style drift. This is where a CTA/Fund bases their performance against a specific benchmark and strategy. Let's say the manager is benched vs. the S&P 500. They would obviously need to focus on that particular market. A style drift would be not that relevant in this case as they're benched against a relatively static index. But if they wanted to focus on the growth sector, they would need to adhere to that. If they starting playing the value sector, they would have style drift.
When a manager deviates from their prescribed method, they will lose clients as they do not want overlay.
2. Margin-to-Equity Ratio (M2E). This is very applicable to retail traders. Its simply the amount of leverage the manager is using vs. their NAV or AUM. Generally, managers look to stay around 20% - 30% M2E. A manager that utilizes a high M2E will most likely experience greater draw-downs than a manager using a smaller M2E. This of course will change daily. Retail should use this to their advantage as well. If you're trading a $100,000 account, leveraging only $20,000 - $30,000 of the account is probably a smart choice. That should answer your question about size.
3. Liquidity risk. Related to M2E, liquidity risk is taken into consideration when looking at the market being traded. For example, if you need to put a substantial amount of capital to work and your trading practice is similar to the intra-day trading retail often does, you will need to take into consideration your impact on the market. Let's say you need to buy into CL with 10,000 cars and your strategy is just trading the day's theme. You may have a hard time there. Can it be done? Of course but it will take a lot of order spreading, etc. Perhaps a better market would be the ES or ZN. Market impact is important not only for fills but also to remain discreet. That is where using algorithmic order entry comes in (Icebergs, VWAP, etc.)
4. Performance risk relative to benchmark and industry index. There are several categories of investment strategies within the CTA/Hedge Fund world. If a manager is performing poorly relative to that index, they are at risk of capital withdrawals. Many institutional investors will place money at multiple managers and will pull that money on the first hint of a problem. Too many have been burned in the past. This category of risk is closely tied to the correlation/style drift risk as well. When a manager is hit with massive capital withdrawals, they experience forced liquidation. A forced liquidation scenario then ties into the liquidity risk category. So, they all come together in that way.
I could go on and on but I think that addresses your question. One thing that is not typically done is using myopic trade performance metrics that are often looked at in retail. These funds have a long time line and have a more zoomed out perspective of trading results starting at the monthly level and on to quarterly and annually. The day-to-day fluctuations are important of course but as long as the general theme are in tact, they're doing their job.
Why have a 100k account at your brokerage if you use only 30k? Brokerages fail, people lose their money.
Personally, in recent years after MFG, PFG and etc, I keep only the minimum amount in my brokerage to cover margin for a full position. And I routinely trade a full position. This means during the day I even occasionally exceed my overnight margin and are into day margin.
There have been instances where I've needed to wire in additional funds to cover margin after a particularly dreadful session. But those are few and far between, and I would rather have to wire in once in a while than wake up with no access to a much larger account that went under utilized the vast majority of time.
Another argument is that I am not a perfect trader. I am only mediocre in my performance some days, and on other days I am down right pathetic. Having a set amount in my brokerage allows me to not trade too far beyond my normal size, and prevents turning a bad day into a catastrophic day in the event I really start to lose my emotional control.
I should also point out what I am describing does not justify all the fools (yes, fools) that leverage $500 margins at brokers with terrible reputations that built a business catering to fresh blood. Those types of accounts are at even more risk. There is an important distinction between capital at risk that resides at your brokerage, and capital at risk that is in play after a phone call/bank wire transfer, in my opinion.
My total trading capital at risk is significantly larger than what I keep at the brokerage at any given moment. This means I am willing to make multiple wires in, should I need to, moving money from one 'account' to another 'account'.
Broker: Advantage, Trading Technologies, OptionsCity, IQ Feed
Trading: CL, NG
Posts: 1,038 since Jul 2010
Thanks Given: 1,713
Thanks Received: 3,863
Mike, the $100k figure is just a round number example. Are there Funds that use higher M2E? Absolutely. In fact, the number I quoted was an average but that ratio will change as the trade matures. My response was in light of the question which was firm risk management practices.
Trading equals risk and risk should be approached with risk capital only. Risk capital is money that can be lost and not destroy a firm's (retail trader's) business. If that means $1,000, $10,000, $100,000 or $1,000,000 the definition is the same.
If people have concerns about the safety of their accounts relative to the firm they use going out of business and wiping out their money, there are a variety of things that can be done. Remember first that client capital is by law, segregated from the firm's capital. There's nothing these laws can do of course in the event of fraud like the examples of MFG and PFG.
What is margin? Margin is simply the amount of money the exchange requires to have on deposit to buy or sell short a futures or options contract. The amounts are determined on a worst case scenario that the market could do in one day. Notice how these amounts change with market volatility.
What's great about the CME's margin requirements is that they are SPAN Margin (standardized portfolio analysis of risk). What that provides the trader/investor is a unique way to protect their capital by purchasing T-Bills as opposed to just sitting in cash. So, if you're worried about that, you can buy and margin T-Bills. Another thing that can be done is use a broker that provides SIPC and/or FDIC insured money market funds that your cash will sweep in to at the end of each day.
Anyway, that's what I meant by that example. I would highly recommend that people use the minimalist amount of leverage when first starting out and of course, can increase that as they become more successful. Those that leverage up their accounts usually aren't around very long.
