The risk of trading : mastering the most important element in financial speculation

226 Pages·2012·8.86 MB·English

by  Toma

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The Risk
of Trading
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Founded in 1807, John Wiley & Sons is the oldest independent publish-
ingcompanyintheUnitedStates.WithofficesinNorthAmerica,Europe,
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the market’s ever-changing temperament and have prospered—some by
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For a list of available titles, visit our Web site at www.WileyFinance.com.
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The Risk
of Trading
Mastering the Most Important
Element in Financial Speculation
MICHAEL TOMA, CRM
JohnWiley&Sons,Inc.
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Copyright (cid:2)C 2012 by Michael Toma. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in
any form or by any means, electronic, mechanical, photocopying, recording, scanning, or oth-
erwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act,
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability or fitness for a particular purpose. No warranty may be created
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tained herein may not be suitable for your situation. You should consult with a professional
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other commercial damages, including but not limited to special, incidental, consequential, or
other damages.
Charts were created using TradeStation. (cid:2)CTradeStation Technologies, Inc. 2001-2011. All
rights reserved. No investment or trading advice, recommendations, or opinions are being
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For general information on our other products and services or for technical support, please
contact our Customer Care Department within the United States at [phone], outside
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LibraryofCongressCataloging-in-PublicationData:
Toma,Michael,1966–
Theriskoftrading:masteringthemostimportantelementinfinancialspeculation/
MichaelToma,CRM.
pagescm.–(Wileytradingseries)
Includesbibliographicalreferencesandindex.
ISBN978-1-118-10083-7(hardback);IBSN978-1-118-22376-5(ebk);
ISBN978-1-118-26207-8(ebk);ISBN978-1-118-23710-6(ebk)
1.Speculation.2.Riskmanagement.I.Title.
HG6015.T662012
332.64(cid:3)5–dc23
2011048577
PrintedintheUnitedStatesofAmerica
10 9 8 7 6 5 4 3 2 1
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Contents
Preface vii
Acknowledgments xiii
About the Author xv
PART I Principles of Risk Management 1
CHAPTER 1 Foundations of Risk Management 3
CHAPTER 2 Five Steps in the Risk
Management Process 11
PART II Managing and Measuring Risk 61
CHAPTER 3 Predictive Analytics Using
Quantitative Analysis 63
CHAPTER 4 Statistical Edge and Its Impact
on Risk 71
CHAPTER 5 Embracing a Culture of Analytics 113
PART III Qualitative Elements of Risk 145
CHAPTER 6 The Human Element: Psychological
Risks of Trading 147
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vi CONTENTS
CHAPTER 7 Preparing for Risk and Loss 161
CHAPTER 8 Business Risk Management
for Traders 181
Bibliography 201
Index 203
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Preface
From corporate offices to trading desk, the two words “risk manage-
ment”togetherhavelongsparkedcuriosity,bewilderment,andeven
confusion. But recently, the profession has received more respect
and recognition in our everyday business world and includes a much big-
ger scope than “those people in legal” or “that guy in charge of insurance
policies.”
The Risk of Trading takes a holistic, or enterprise-based, approach
that encompasses not only risks on a trade, but also for the trader and
ultimatelythebusinessoftrading.
WHY USE A DATA-DRIVEN APPROACH?
Anyone in the trading jungle knows that a comparison is often made be-
tweentradingandgambling.Thisbooklooksdeeplyintothisanalogyand
discovers the statistical principles are, in fact, quite similar. When I first
mentionarisk-basedapproachtostock,futures,oroptionstradingtothe
casualinvestor,thewords“risky”and“gambling”oftenfollow.Usingame-
chanical method to trading supported by a statistically strict data-driven
approachofteninvitesevenmorequestions.
“Youreallydon’tcarewherethemarketisgoing?”“Don’tyouwantto
beatthemarket?”“Isn’tthatabitboring?”“Isthatwhatyoudoallday?”My
responsetotheseallegedmarket-predictorsis,“Idon’tfindwinningboring
atall.IexecutemyplanwhenIhaveanedge.Alltherulesareinmyplan.
What I do is execute my plan with precision just like a project manager
building a house or a homeowner mowing the lawn. I’m not concerned
about beating the market. I just focus on executing winning trades, and I
onlyexecutewhenIhaveabetterchanceofwinningthanlosing.”
Thereisacertainlevelofpridewhenso-calledtraderstalkabouttheir
successinpredictingmarketmovements.Anyonecandoitforatimewith-
out any charts, data, or trading experience. You have about a coin-flip
chance of being right, and most just hype the few successful predictions
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viii PREFACE
over and over again. There’s no pressure for them, of course, since most
ofthetimethereisn’tanyhard-earnedcapitalatrisk.Performinghoursof
analysistakesmuchmoreenergyandcertainlycomesacrossaslesssexy,
ifinfactdataanalysiscanhavesuchanalluringappeal.Thecasualinvestor
tendstoberesistanttoanyformofanalytics,sincetheworditselfisreflec-
tiveoflotsofworkandanalysis.Whenthesemethodsarepresentedwith
simplicity, the better the chance that more will want to hear about them.
Combining the conversation with success in trading the markets usually
resultsinacaptiveaudience.
Establishing a culture of trading analytics and metrics is about per-
formingstatisticalanalysistoshifttheoddswhereonecanbesuccessful.
Thereisavaluepropositioninusinginformationandeventsthathaveoc-
curredinthepasttopredicttheprobabilityoftheiroccurringinthefuture
under similar circumstances. Although sometimes associated with a geek
dynamic, a data-driven approach is evident in many successful areas of
business.Serviceindustriescurrentlyusecustomerandvendordatatode-
termine methods to improve quality of service. Internal risk control data
generatedfromprocessimprovementassessmentscanassistinimproving
productqualityandefficiency.Data-drivendecisionmakingisevenusedto
determineifafootballquarterbackshouldpassorhandoffduringcertain
situations. The book Bringing Down the House describes the MIT black-
jack team’swinning formulaforbeating the casinos using data-driven an-
alytics. The book takes a microscopic approach to using data to manage
riskandidentifythoseopportunitiesthatpresentanadvantage.Simplyput,
pastdataandstatisticsthathaveprovidedpositiveresultsinyourtrading
will tend to continue to do so in similar market conditions, thus provid-
ingyouwiththecompetitiveadvantageeagerlysoughtintrading.Combine
thismethodologywithsolidriskplanning,andyounowhaveaccesstoone
ofthemostpowerfultradingtools.
Mutualfundcompanies,hedgefunds,andproprietaryfirmshaveused
risk protocols for some time, but only recently has the average swing or
day trader making a living from his or her basement computer had a risk
component to trading. It is now commonplace to have a risk section ap-
propriatelytitledinatrader’stradingplan;oratleastforthosewhoinfact
havecreatedone.
The titleofthisbook reflectstheessentialprinciples oftheriskman-
agement concept required in trading stock, ETFs, futures, or other secu-
rities and derivatives. Any type of loss, financial, physical, and even loss
ofopportunityisafactoflife.Iftheywerenot,howweoptimizethebest
use of the ways to minimize loss would be meaningless and unnecessary.
Onetrader’sworkvenuemaybevastlydifferentthananother’sinthesame
profession.Onecanperformhisorhercraftatahedgefund,propdesk,or
atthekitchentable.Inthisbook,Itaketradersonanassessmentjourney