Risk Management In Trading: Techniques To Drive Profitability Of Hedge Funds And Trading Desks

This book focuses on techniques that professional traders use to assist in making decisions. The first three chapters establish the building blocks that are used in the rest of the text. The first chapter introduces trading and two major types of professional traders (hedge funds and proprietary trading desks). The second chapter discusses the major financial markets, and the third describes some of the terminology used by professional traders. The final six chapters of the book describe decisions that are made by traders.

Risk avoidance and acceptance are discussed in the chapter titled “Backtesting and Trade Forensics”. Avoiding risk is a strategic decision that involves determining the markets where a trader has the biggest advantage relative to other traders. It is difficult to do all things well, and successful traders often have to choose some opportunities to avoid. Specializing allows traders to concentrate on the opportunities that are the most promising.

Techniques to control risk are discussed in the chapters on “Mark to Market”, “Value at Risk”, “Options and Non-Linear Risks”, and “Credit Value Adjustments”. In a nutshell, the primary way to control risks is to set limits on how much risk will be allowable and then develop ways to quantify those risks on a daily basis. Adopting a consistent framework for risk allows different types of risks to be compared to one another.

Transferring risk is primarily discussed in the chapters on “Hedging” and “Credit Value Adjustments”. For a cost, traders can selectively pay to remove risks from their trading portfolios. However, there is a cost associated with removing risk and tends to remove the possibility for both profit and loss. When transferring risk, traders need to be careful that they aren’t replacing an uncertain profit with a certain loss.

For people reading the book, there are a couple of themes that run through the book. First, risk management can be risky. For example, arbitrary rules to liquidate trading portfolios under various circumstances can lead to massive trading losses if it is difficult to transact on that day. Any trading decision that isn’t based on the goal of maximizing one’s profits is a decision that needs to be scrutinized by multiple people.

A second theme running through the book is that details are important. Risk management simplifies details to make decisions easier for decision makers. However, this simplification can lead to problems since critical details are at danger of being lost. There isn’t always a set of rules that indicates how much is too little or too much. There is no substitute for somebody knowing what is actually going on being involved in decisions.

DAVIS W. EDWARDS, FRM, ERP, is a senior manager in Deloitte’s Energy Derivatives Pricing Center and a specialist on the topics of risk management, statistical analysis, and valuation of financial derivatives. Prior to joining Deloitte, he worked as a director of credit risk at Macquarie Bank and senior managing director on the proprietary trading desk at Bear Stearns. Davis was an early pioneer in the development of artificial intelligence execution and order-matching systems that revolutionized the NYSE and NASDAQ. Davis is a Certified Energy Risk Professional (ERP) and Financial Risk Manager (FRM) with the Global Association of Risk Professionals and directs the organization’s professional chapter in Houston, Texas.