Risk Management & Trading Systems
Let’s Define Risk :
In the simplest language, risk boils down to the amount of money lost due to uncertainties from a particular trade or a series of trades.
Broad Categories of Risks in Financial Markets :
Some of the risks that a trader is exposed to :
- Liquidity Risk: Trading in liquid (low volume) instruments can make it difficult to enter and exit positions due to less number of Buyers/Sellers to fulfill the trade quantities.
- Psychological Risk: Without a proper trading system in place, traders might suffer due to their own emotions by making irrational decisions.
- Technology Risk: There are various levels of technologies involved during trading. Most vulnerable being the platforms running on local devices of the traders.
- Risk of Ruin: The risk of wiping out the complete trading capital.
- Execution Risk: The trader needs to monitor and track various different Stocks or instruments and strategies which might lead to inefficient execution especially for intra-day traders.
- Slippage Risk: If the bid-ask spread is huge, it might result in a lot of slippage. Liquid instruments have low slippage.
- Volatility Risk: If the stops are not placed taking volatility into account, it might result in false triggering of stops.
What is backtesting and how can it help in mitigating risk? :
Backtesting involves evaluating the performance of a set of buy and sell conditions that make up a strategy, on historical price and/or volume data (All the indicators are mathematically manipulated price and/or volume date) to gauze the Rewards and Risks associated with trading any particular strategy. Backtesting is a very crucial part of system development.
Risk Management using Streak :
We have made sure to provide risk management features at every level, from strategy building, testing to execution. There can be categorized on three different levels :
Risk Management at Level 1, Backesting :
The platform provides various tools for a trader to understand and manage risk. Even before executing the trade, traders can understand the Rewards and risks associated with trading any strategy on any instruments by Backtesting their strategies.
Understanding Risk/Reward components of backtest :
How do we look at the level 1 components combined together? :
- Returns & Max Drawdown : The ratio of Net profit % to Max DD can be calculated to assess the risk adjusted returns. It is also called MAR Ratio. It is one of the best tools to initially assess any trading system. Returns can be improved by improving Entry conditions, Take profit% etc. Drawdowns can be reduced by incorporating better exit conditions and adjusting stop loss.
- Win/Loss ratio : Higher win to loss ratio is always preferable as it minimizes risk of ruin. Win to loss ratio must be in accordance with Stop-loss and Take-profit. A system with a very low win/loss ratio must have a very low risk/reward ratio to remain profitable. Risk/Reward ratio in this case can be adjusted by changing stop Loss and Target Profit %.
- Average Gain/Winning Trade : This ratio can be compared with max gain. If the max gain is much higher than the ratio, this may indicate that the overall profit is influenced by one outlier. Similarly Average Loss/Losing Trade can be compared with Max loss.
- WS, LS (Winning Streak, Losing Streak) : These metrics might help one decide when he might want to stop trading after achieving a certain number of continuous winning trades. Conversely it might also help you decide when to take the strategy live if you have already been paper trading using the strategy (You would want to take the algo live in the market when there has already been a significant number of losing streaks during paper trading). Automated paper trading option is also provided on the Streak platform.
Risk Management at level 2, Paper-Trading :
- Automated paper trading option is provided for traders to evaluate their trading strategies in the live market using virtual money.
- Paper trading option will execute the strategy live using real market data with virtual money.
- It is the most efficient method to test the strategy in the live market without risking any real capital in various market segments.
- The results can be seen at the end of the trading day on the deployed panel of Streak.
Risk Management at level 3, Execution/Live Trading :
Various different Stop-loss and Take profit mechanisms have been implemented to provide traders with flexibility to exit trades by securing profits if the target is reached or protect capital if the stop-loss is hit.
The orders are placed on the exchange within seconds of signal generation to avoid price gaps.
The Bottom Line :
- Backtesting is a very crucial part of developing any trading systems to understand the risks and returns offered by your trading strategy and to carry out optimizations.
- Once the strategy is developed, it is important to consistently stick to the strategy.
- Risk management should be implemented at every level of trading.
- Risk management is essential to protect your trading capital.
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