Algorithmic Trading: Winning Strategies and Their Rationale

CHAPTER 8

Risk Management

Risk management means different things to different people. To novice traders, risk management is driven by “loss aversion”: we simply don't like the feeling of losing money. In fact, research has suggested that the average human being needs to have the potential for making $2 to compensate for the risk of losing $1, which may explain why a Sharpe ratio of 2 is so emotionally appealing (Kahneman, 2011). However, this dislike of risk in itself is not rational. Our goal should be the maximization of long-term equity growth, and we avoid risk only insofar as it interferes with this goal. Risk management in this chapter is based on this objective.

The key concept in risk management is the prudent use of leverage, which we can optimize via the Kelly formula or some numerical methods that maximize compounded growth rate. But sometimes reality forces us to limit the maximum drawdown of an account. One obvious way of accomplishing this is the use of stop loss, but it is often problematic. The other way is constant proportion portfolio insurance, which tries to maximize the upside of the account in addition to preventing large drawdowns. Both will be discussed here. Finally, it may be wise to avoid trading altogether during times when the risk of loss is high. We will investigate whether the use of certain leading indicators of risk is an effective loss-avoidance technique.

■ Optimal Leverage

It is easy to say that we need to be prudent when using leverage, but ...