Trading Risk

A revolutionary system for fearless trading without excessive risk "Trading Risk provides a useful and intuitive roadmap of the risk management process, as written by an individual with unique experience and insight into this topic. It is an engaging read and covers complex subject matter in a straightforward and often-entertaining manner."
- Stanley Shopkorn, Shopkorn Associates
"Ken Grant's eminently readable new book on risk management is a rare blend of theory and practical applications. It is a great starting point for the novice and deep enough for the experienced practitioner."
- Mark R. Graham, Managing Partner, Blue Elite Fund, Ltd.
"This book describes a very practical approach to risk management in a lucid and entertaining manner. Anyone concerned with the topic of risk management ought to find it of interest."
- Susan Estes, Managing Director, Countrywide Securities
"Thoughtful, unique, detailed, actually enjoyable, and comprehensible reading for what is normally a boring and confusing topic."
- Dwight Anderson, President, Osprei Management, LP
"A must-read for risk managers of companies of all sizes who want to preserve capital and take practical advantage of trends in the marketplace. This is a clearly written, funny, and entertaining guide to a very serious topic that affects all corporations. This very complex topic was simplified and made easy to understand by a true expert in the art of risk management."
- Phupinder Gill, Managing Director & President
Chicago Mercantile Exchange

Preface ix
Acknowledgments xiv
Chapter 1 The Risk Management Investment 1
Chapter 2 Setting Performance Objectives 19
Optimal Target Return 21
Nominal Target Return 24
Stop-Out Level 26
The Beach 32
Chapter 3 Understanding the Profit/Loss Patterns over Time 37
And Now to Statistics, but First a Word (or More) about Time Series Construction 39
Time Units 40
Time Spans 43
Graphical Representation of Daily P/L 48
Histogram of P/L Observations 51
Statistics 53
A Tribute to Sir Isaac Newton 53
Average P/L 56
Standard Deviation 57
Sharpe Ratio 65
Median P/L 68
Percentage of Winning Days 68
Performance Ratio, Average P/L, Winning Days versus Losing Days 69
Drawdown 70
Correlations 73
Putting It All Together 79
Chapter 4 The Risk Components of an Individual Portfolio 81
Historical Volatility 84
Options Implied Volatility 86
Correlation 90
Value at Risk (VaR) 91
Justification for VaR Calculations 92
Types of VaR Calculations 94
Testing VaR Accuracy 98
Setting VaR Parameters 99
Use of VaR Calculation in Portfolio Management 102
Scenario Analysis 104
Technical Analysis 106
Chapter 5 Setting Appropriate Exposure Levels (Rule 1) 109
Determining the Appropriate Ranges of Exposure 110
Method 1: Inverted Sharpe Ratio 111
Method 2: Managing Volatility as a Percentage of Trading Capital 114
Drawdowns and Netting Risk 129
Asymmetric Payoff Function 130
Chapter 6 Adjusting Portfolio Exposure (Rule 2) 133
Size of Individual Positions 134
Directional Bias 135
Position Level Volatility 141
Time Horizon 142
Diversification 144
Leverage 146
Optionality 148
Nonlinear Pricing Dynamics 149
Relationship between Strike Price and Underlying Price (Moneyness) 149
Implied Volatility 150
Asymmetric Payoff Functions 150
Leverage Characteristics 151
Summary 154
Chapter 7 The Risk Components of an Individual Trade 155
Your Transaction Performance 156
Key Components of a Transactions-Level Database 157
Defining a Transaction 158
Position Snapshot Statistics 160
Core Transactions-Level Statistics 161
Trade Level P/L 162
Holding Period 162
Average P/L 163
P/L per Dollar Invested (Weighted Average P/L) 164
Average Holding Period 164
P/L by Security (P/L Attribution) 165
Long Side P/L versus Short Side P/L 166
Correlation Analysis 168
Number of Daily Transactions 170
Capital Invested 171
Net Market Value (Raw) 172
Net Market Value (Absolute Value) 173
Number of Positions 174
Holding Periods 175
Volatility/VaR 177
Other Correlations 179
Final Word on Correlation 179
Performance Success Metrics 184
Methods for Improving Performance Ratios 189
Performance Ratio Components 190
Maximizing Your P/L 192
Profitability Concentration (90/10) Ratio 200
Putting It All Together 208
Chapter 8 Bringin' It on Home 213
Make a Plan and Stick to It 214
If the Plan's Not Working, Change the Plan 218
Seek to Trade with an "Edge" 219
Structural Inefficiencies 220
Methodological Inefficiencies 223
Play Your P/L 226
Avoid Surprises-Especially to Yourself 234
Seek to Maximize Your Performance at the Margin 236
Seek Nonmonetary Benefits 237
Apply Liberal Doses of Humility and Humor 242
Be Healthy/Cultivate Other Interests 244
Appendix Optimal f and Risk of Ruin 245
Optimal f 246
Risk of Ruin 250
Index 253