applied commonsense, without complex formulas, for a long time. Some of these principles are:
1. Don’t risk very much of your total capital on any one trade. The total risked shouldallow you to comfortably survive more losses than you would normally expect.
2. With whatever method you use, determine the maximum loss for the current tradein advance. Many floor traders believe that their survival is the result of being thefirst to exit a trade. (“I didn't pay to get in, but where do I pay to get out?”)
3. Exiting a trade is more difficult than entering because the timing is nog always yours.Exiting quickly is often safer than being clever.
4, Stay with your trading philosophy. If you are a trend follower, then keep lossessmall and let profits run. You can’t be a trend follower by taking many small lossesand a few small profits.
5. Every system has a trading profile. Be sure that profile is agreeable to you.
6. Plan for contingencies. Not everything goes as planned, and you must be preparedfor infrequent, but important exceptions.
LIQUIDITY
The realities of trading are directly related to the liquidity of the market. Even though liq-uidity can have more than one meaning, lack of liquidity has only one trading result: poorexecution. A liquid market does not necessarily mean good fills, but an illiquid marketassures bad ones. Two types of illiquidity ace most often encountered in the markets:
1. Fast-moving markets, in which there are mostly buyers or sellers, and few tradersare willing to take the other side of the position. -
2. Inactive markets, usually in the deferred months in which there is less interest in ei-ther hedging or speculating,
The fast market is the result of a supply-demand imbalance, or perceived imbalance, whereeveryone is in agreement on the direction the market should move. The few hedgers andtraders willing to take a position do little to offset the vast number of orders that flood thefloor, pushing the price in the direction of the trend. In the inactive market, a premiummust be paid to attract another trader to take the opposite trade. This will only succeed in 
 
590RISK CONTROL
an inactive market when the bid or offered price ly ive .red pri: _ y the price clearly appears to give the other trader aThe il ty es the mo: ‘08 eal’ | iquidi of a market produces the most important execution cost, often greaterhan a sizable commission and sometimes unreasonably large. Ginter and Richie? have
described this as a function of the ize, volume, and the speed of the market, ina sin-A order size, » the hi , ina sin.
C=Kx 2XYEX Ly
where C= cost of execution due to liquiditysize of the order entered= volatility of the markett volume of the market (all deliveries)'o = volume of the specific option (delive:K = constant factor (Gelivery month)
     
‘The volatili , .ene rolatiy Vmigh be the daily range (high minus low), of factor of the standardprovide a measure of how muchdev 0 . uch volume wipe market plies ligaidity choc of points. The total volume (liquidity) Z, eerliquidity due to interdelivery spreading. Vol ©
B 5 ) g. Volume also serve: -
surement of the Seneral incest in the product. More active trading in other contractibility for trading in all months given the right ci
ih y given the right circumstances.
ane Te Constant factor K will vary according to the nature of the order being placed and
the current dizecton of the price with regard to that order. If prices are moving higher and
a buy order is placed, K wil be large; if pices are moving higher and a sell order is placed
Kwill bes mallet. The investor can see that trading overhead, including both commissions‘sts, will have considerably greater imy
and pact on systems th:
re often, have smaller average profits, and trade in the direction of the trend ‘Ginea a
choice between systems ofqual gross profit ifewest trades in the most liquid markets, she levestor should favor the method ofCAPITALSuccess does not depend on having enough capital, but in using it properly.Dixon G. Watts
Ey itsEvery ope of system has ts own profitand:oss cyte, depending on what price patterns orring, A simple moving average will be i ibehavior iis : profitable in a trendgad will jose ina nontrending one; a system that operates within a trading range leasefrom sontrending situations. it has been estimated that prices spend 70% to 80% of theirtots jing movement, therefore, when using a trend-fc ing sy° n mo 5 -foll iis likely that trading will begin in a nontrending period. Because the risk ofthe system dur.ing a sustained trendtess market may be unknown, i is best ro start small Find the minifui amount that can be used to follow the system n a representative manner Dura thstars period, ii best to pent on 10% or 20% of capital than lose on 100%, awaysslowly actual wading pesformance is rarely as g6od as expected canesablish the maximum: margin based on the exp eri of norcane blah th maximus agin be ‘periences of nontrending markers. Ifrain total margia well under 50% of available capital. Th iHons review ways of increasing margin and compounding pron. ~The following sec-chap betsilication reduces both risk and reward; done propesy the risk is reduced morard. Using a well-distibuted portfolio for a system whose risks are knows, a7
 
 
  
* G. Ginter and J. Richie, “Data Errors a1 istortions,” in Technical Analysis in Commodities, Perry J. Kaurs and Price Distortions,” s: i‘ " i by 5, Perry J.
ecdbeaaaibt
MEASURING RISK - Sollarger portion of the total capital can be allocated to margin. Advantages of statisticsbecome apparent in the netting out of profits and losses daily; the majority of trades willmove in a favorable direction a majority of the time. The volatility of a portfolio will bedampened by this netting effect; a trade with a slow upward trend and a distant stop-losswill be offset by a slow downward trending position in another commodity.
An undercapitalized account cannot be traded safely by selecting a system with a favor-able risk-reward profile. Because there is very little staying power, the trader must acceptthe fact that there is a small chance of success. There are two choices, based on the per-sonality of the trader:
1. Try for the maximum profit possible on a single trade with the capital available. If it
loses, trading is halted. If it profits, there may be enough capital for a diversified ap-
proach.
2. Take a low-risk approach, which allows the most losses for the given capital. This in-ceeases the time in the market, with comparably reduced profits. It is necessary 10have an unusually long run of small profits to reach a point of success.
‘There are two important rules in managing an account: (1) Don't meet margit: calls,which implies that a margin call represents an objective identification ofa bad trade, or asystem that is not meeting expectations. A margin call is a time fo review trading perfornance. (2) Liquidate your worst position when lightening up. The profitable trades haveproved that they are trending or performing properly; the losing ones have proved they arenot. Stay with the good positions and liquidate the worst.
‘The management of capital is especially important at the beginning stages of trading,although it continually affects results. At some point, every trader wan’s © compoundprofits—a system that is profitable can be more profitable. This philosophy most oftenFeads to disastrous results. The ne». sections present methods for measuring risk, followedby a traditional and a conservative approach to compounding and increasing leverage
MEASURING RISK
An important part of both system development and money management is the recognition,measurement, and ultimately, the limiting of risk. Broadly speaking, money managementie che art of limiting the Tisk of a portfolio while maximizing its return. To perform thesetasks, it is first necessary to select, or develop, profitable trading strategies t© be used forcach commodity, It is the results of these strategies, both simulated and real, that will becred to structure a risk-controlled trading program (see the discussion of "System Trade-
Offs” in Chapter 22).
Selecting a Trading Model
A trading model is a set of rules and formulas that, when applied to 2 price series, yieldstrading signals. These signals might be as simple as buy and sell Market on Close or com-plex contingent orders involving multiple delivery months and markets. To simulateFogults, the model must be well defined; that is, all the rules must be logically stated andprogrammable. Interpretive methods, such as many charting techniques, cannot be simu-pied: they depend on patterns that cannot be defined in advance. The use of actual tradingresults for later analysis is always preferable and is not limited to computerized systems.Suppose there is a choice of systems to trade, and the daily equity of each is available.If only one can be selected, which should it be? There are some characteristics of perfor-
mance that are universal:
s Norm Strahm, “Preference Space Evaluation of Trading System Performance,” in Handbook of Futures Markets,
Perry J. Kaufman (ed.) (John Wiley & Sons, New York, 1984) 
   
pe
  
(Ribena
 
 
 
epee ai KOE REE
“92 RISK CONTROL
1. Larger profits are better than smaller profits.2. Small, short-term fluctuations are better than large, short-term fluctuations.3. Upward equity surges (profits) are better than downward surges (losses).
Naive Performance Criteria
‘The use of a single piece of information is not sufficient to satisfy the basic criteria statedpreviously. The system with the maximum profit is not necessarily a good choice. Theremight have been a run of losses greater than the investment before profitability wasachieved. Similarly, the risk alone is not sensible. The system with the smallest risk is onethat never trades. A valid performance measurement technique must include a comparisonof risk and reward.
The Sharpe RatioThe classic measurement of performance is the Sharpe Ratio (SR), expressed as
E-Io
where E is the expected return, / is the risk-free interest rate, and o is the standard devia-tion, or fluctuation, of the periodic returns (for example, the yearly returns). For practicalPurposes, £ should be an annualized rate of return in percent, if you expect that return to‘continue, and J is often omitted. The inclusion of / is important when a large part of theperformance is a contribution of interest on the investment, or when the equity streamsbeing compared are inconsistent in their use of interest income. The standard deviation ofthe equity is a standard way of measuring risk.
The Sharpe Ratio satisfies the first criterion, that all else being equal, higher profits are
better. It does not satisfy either of the other requirements, because it cannot distinguish .
between:
1. Consecutive small losses (System B) and alternating small losses (System A)2. Large surges of profits and large losses (Figure 23-3)
Clearly, System A is best in both cases.
\Average Maximum Retracement
Schwager‘ has presented a comprehensive study of evaluation techniques. Although eachmethod may emphasize a particular equity trait, he seems to favor the average maximumretracement (AMR). This method answers the question: “For each day, what would be theretracement if one had started trading the system on the worst possible trade entry date?"The AMR is the average of the daily maximum retracement values.
AMR = = POS(MCE, ~ TE))“where L_[xifx>oPOS) = loitx< a
   
losed-out equity (re:otal equity ca day éN = total number of days of equity data
ized profits) on any trade eniry date prior to ¢
  
* Jack D. Schwager, A Complete Guide to the Futures Markets (John Wiley & Sons, New York, 1984).
 
 
MEASURING RISK ~ 593
 
FIGURE 23-3 Two cases in which the Sharpe Ratio fails. (a) The order in which profits andlosses occur. (b) Surges in profits versus evenly distributed losses.
 
  
System A
    
/ system B1 System
Woe
 
system A
   
(y)—
When TE, > MCE, all traders will bave a profit on day i, regardless of when they began.Schwager suggests that a much simpler computation would use only the iow total equityday of each month; it would give a rough but good approximation.
Largest Loss
Measurements such as Schwager’s AMR, and even the basic standard deviation, are goodtechniques for comparing the long-term performance of one system against another; theylack a certain reality of simply looking at the largest loss seen over the test periods. JohnSweeney calls this the maximum adverse excursion,* claiming that traders should mini-mize the size of their largest loss. :
Consider the standard deviation of equity changes, showing that in any month there isa 68% chance that your returns will be between 15% and -5% (a mean of 5% and a stan-dard deviation of 10%). There is only a 2.5% chance that you will lose more than 15% in 1month (2 standard deviations); therefore, there is a 50% chance you Will lose that 15% in1 of the first 20 months (20 + 2.5). Yet probability shows that you should lose more, if youkeep trading, or less if you stop sooner. ; ;
The largest historic loss, called the maximum drawdown, is a practical alternative. Itsimply states that the trading program did, for example, lose 15% during 1 month of a3-year test. While it is possible, and even likely, that the program will have a larger loss inthe fucure, you must be prepared for a 15% loss in a single month.
3 John Sweeney, “Maximum Adverse Excursions for Stops,” Technical Analysis of Stocks & Comniodities (April1987). 
 
594RISK CONTROL,
Potential Risk .
The measurement of risk may include other safety factors. Once a lary
it is likely that a larger one may follow. It is unreasonable to think haat fares losses val
be smaller than the maximum already experienced. This potential for loss can be
expressed 2s a probability by calculating the standard deviation of all equity drops, mes
sured from lows to previous high equity points, and creating an equity drop ratio (EDR)E
EDR = apy = E/@stdev ED)
 
where £ is the annualized return (equity), and o(£D) is the iali . tandard deviation of the edrops. Although this is not far from Schwager's approach, it satisfies all three of the oriennal criteria: higher profits are favored, the order of profits and losses will result in largerand smaller net equity drops, and large gains are not penaliand smaller net equi larg penalized because only the drops are
The conservative investors may want to include some addi i
conse ¢ additional simple considerati
of potential risk. All else being equal, systems with greater risk will be: mons
1. Those tested with samples that are too small
2. Those that have not shown any (or few) equity drops
3. Those that concentrate on fewer product groups (not properly diversified)4, Those that compound positions
Efficient Frontier = —
Ics always helpful to visualize the relative risk of how one system performs with respect 0orhers. A plot of. each system using its return and risk as coordinates will appear as in Fig-Clearly, the best system would be the one that had the highest retu ihad the same risk; or A, the one with the lowest risk, if it sigh had the higher arathree systems, 4, B, and C, are similar because they have the highest returns for their levelof risk. However, each used a different degree of leverage, or reserves, and therefore hadclose to the same profit to risk ratio but in different magnitudes. The choice between sys-tems, 8, and Cisa personal preference discussed earlier in this chapter. Theoretically, thebest choice is found by drawing a straight line from the risk-free rate of return (on the leftscale) to the tangent point on the efficient frontier. This selection avoids the combinationsin which risk increases more quickly than reward.
 
FIGURE 23-4 Efficient frontier.
Efficient frontier - -
Annualized return
 
Risk measurement
we
|
 
MEASURING RISK —_~ 595
Risk Characteristics of Systems
‘The selection of a type of trading approach implies the type of risk you are willing to takeon each trade. The difference between trend and countertrend systems was discussed inthe section System Trade-Offs in Chapter 22 (“Practical Considerations”). In general, atrend system has many smaller losses and fewer larger profits; a countertrend system hasthe opposite, many smaller profits and fewer larger losses. This is similar to the choicesavailable with gambling strategies.
Even among trending systems there are enormous differences in trading risk. A typicalmoving average system, which qualifies under conservation of capital, keeps individualtrade losses small compared with individual profits, but may have a series of losses that addup to one very large continuous loss. In addition, trend systems fail when they encountera sideways period, and frequently reverse from long to short and back again until pricesfinally pick a direction. Tests show that you cannot reduce the number of trend tradesbelow a threshold level, even if you make the trend period very long. It always gets caughtin a sideways price pattern that generates a series of small losses.
A breakout system, the other very popular trending technique, exchanges a muchlarger risk for much greater reliability than the moving average or exponential smoothing.When a new long position is entered based on a new high price for a specific time period,the risk is defined as the price needed to make a new low for the same period. Therefore,the trade risk at the time of entry is the difference between the high and low for the period,
 
trade_risk = @highest(close,period) - @lowest(close, period)
If the highest high and lowest low are used, the risk can be much greater.
‘The advantage of the moving average or smoothing method is that individual losses aresmall. Using the breakout approach, the advantage is that the method does not demand asmuch of price movement; that is, prices may be very erratic, and take as long as needed tomove to a new level, as long as they do not make a new low. It seems illogical that, if priceshad given a buy signal by moving to new high levels because something fundamental wasaffecting the market, prices could turn around and make a new low. That would indicatethat the reason behind this move has disappeared.
Risk-Adjusted Returns .‘The decision whether to choose one trading approach with higher returns and higher risk,or another with smaller returns and lower risk can be resolved by converting performanceto an annualized, risk-adjusted return. Using any method for measuring risk—a standarddeviation of monthly equity changes, average maximum retracement, or even largest draw-down-—divide the annualized rate of return by the risk to get the risk-adjusted rate ofreturn. The highest value is the better choice.
Time to Recovery -
A trading program that recovers quickly from losses is more desirable than a program thatlingers at its lowest level of loss. The fact that the first program recovers quickly does notchange its level of risk, only its practical appeal. ~
How Much Bigger Could the Risk Really Be? .Many of the risk measurements described in this section attempt to express the probabil:ity of a future loss. Within reason, many of them succeed. An investor must distinguishbetween the calculated probability and the effects of a real loss. If there was only 2 1%chance of a 50% loss in a single month, thgn by the 50ch month there would have been a50% chance of a 50% loss, There is also a'large error factor in most-of these calculationsbecause the amount of data used to find the statistics was too small. If 100 cases were used 
 
596 RISK CONTROL
 
there is still a 10% change of error in the results. The value of the measurement is alsodependent upon the period in the market that was used to create these values; the risk incrude oil was exceptionally high during the Gulf War. If that period is not included, the riskof trading crude oil might seem very low.
LEVERAGE
The consequences of leverage are readily seen in a risk/reward analysis, but it also plays acrucial role in the trading strategy itself. Futures markets offer exceptionally high leverageopportunity, and most traders and analysts act as though they are obligated to take advan-tage of the maximum allowable. Without leverage, futures prices show no more risk thanstocks.
Consider the case of an investor with the substantial sum of $50,000 allocated to futurestrading. If the price of soybeans is $6.00 per bushel and silver is $7.00 per ounce, a 5,000-bushel contract of soybeans is worth $30,000 and a 5,000-ounce contract of silver is valuedat $35,000. With no leverage, the investor could only purchase one contract with the cer-tainty of being able to hold that contract as long as necessary to achieve a profit. Let usassume that, because of fundamental reasons, the investor believes that soybean prices willmove to $8 per bushel. and silver to $11 per ounce within the next 6 months. The nonan-nualized gross return on investment will be 33% for soybeans and 57% for silver, equivalenttoa 20% and 40% return on $50,000, respectively. With no leverage and not endugh moneyto invest in both, the choice must be silver, which has the highest return; in neither casecould their be any risk of ruin. In both cases there would be surplus capital.
But 100% capitalization is hardly necessary. Even the most conservative investor wouldagree that the price of either commodity would not drop to 30% of the current value;therefore, there is no significant risk in capitalizing 70%, rather than 100%, of the contractvalues. By reducing the individual capitalizations, the investor can then purchase both sil-ver and soybeans, thus adding diversification and a much higher return on the availableinvestment. Table 23-1 shows that 30% leverage would increase the return on investmentfrom 40% to 60%, in addition to the way in which the investment could be allocated, givendifferent levels of capitalization.
As the capitalization is lowered and the leverage increased, both risk and return getrapidly larger. In Table 23-1, there are certain levels which are more significant than others:
 
TABLE 23-1 Varying the Leverage of an Investment
 
 
 
Soybeans Silver Total ReturnLeverage Needed Profit Needed Profit Profit Needed -
(4) Qy (3) (3) Qy ($) (3) (3) 3) PIL
° © 30,000 1 35,000 © "20,000 © 20,000 35,000 4010 -o 27,000 1 31,500 --20,000 31,800 31,500 4020 0 24,000 1 28,000 20,000 28,000 28,000 4030 1 21,000 10,000 1 24500 20,000 30,000 45,500 6040 1 48,000 10,000 1 21,000 20,000» 30,000 39,000 6050 1 15,000 10,000 2 17,500 40,000» $0,000 50,000 10060 1 12,900 10,060 2 14900 40,000» $0,000 49,000 10070 2 9,000 20,060 3 19500 60,000» 80,000 49,500 ‘16080 3 6,000 30,000 4 7,000 -80,000--'110,000 46,000 22090 7 3,000 70,900 8 3.500 160,000 230,000 49,000 4605 15 1500 150,000 «15 1,750 300,000 450,000 48,750: 900
—
 
LEVERAGE - 597
30% leverage, the point at which there is added diversification, an increase in return,and a negligible increase in risk.
90% leverage, equivalent to exchange minimum margin levels.‘ It allows well-capitalized traders to have margins averaging about 10% of the contract value.
95% leverage, equivalent to the margin level given to hedgers and spreaders, based onowning the physical product as offsetting risk.
‘At 90% leverage, the investor is required to use $49,000 for margin. The positions maybe maintained without an additional investment as long as the account does not show aloss in excess of $12,250” (with a total of 30 contracts, i.e., equivalent to a loss of $408 percontract, or 8¢ per ounce of silver and 8¢ per bushel of soybeans). Because the daily trad-ing range of both commodities exceeds that value, it is very possible to have a margin callon the first day the position is established. It is not possible for an investor to hold this
position for long.
Reserves
Most professional money managers use reserves to reduce the leverage and risk, therebyincreasing their staying power. The size of the reserves usually averages about 60% of thecapital; however, ranges of 10% to 80% have been known. The use of a 50% reserve effec-tively halves the returns and the risk (Figure 23-5).
Looking again at Table 23-1, there is now only $25,000 of capital available for margin.If excharige minimum margin rates are used, there is 90% leverage available; this meanseach contract of soybeans requires a $3,000 deposit and each contract of silver $3,500. The80% leverage line, with one-half the margin shown, would require a total margin commit.ment of $23,000, slightly under our limits. The net effect of 90% leverage on one-half thetotal investment is the same as 45% leverage. Returns are:
© In ftures trading, initial margin is the minimum amount required on deposit when the position is entered
7 Maintenance margin is the level of capitalization that must be maintained in the account. Losses that reduceequity to below 75% (the current maintenance margin level) of the initial margin level require the investor 0reestablish the capitalization to the full initial level.
eeeFIGURE 23-5 Varying reserves, assuming a 50% return on $50,000 (with standard reserves = I).
@ 100%3z550%=So.€ 25%2=
02 1 2 aFactor of reserves
mR, 
399
 
 
 
 
“598 RISK CONTROL DIVERSIFICATION =~= mentals; however, a radical change in the value of the U.S. dollar or interest rates3 contracts of soybeans x $10,000 profit = $30,000 could move all prices in the same direction. For example, rising interest rates are4 contracts of silver x $20,000 profit = SSo'000 bad for commodities that must be stored, because it increases those costs. In turn,fotal profit K is i ‘ her th: larger -Net return on investment 180% investors will sell gold and farmers will sell soybeans rather than pay a larger carrying charge.Slow changes in the value of the U.S. dollar will affect export markets; changesDIVERSIFICATION in interest rates will directly impact the stock index. A crisis in the potato market,if ne tisk: it i : ; however, has little effect on other areas of the economy. When selecting those mar-Diversification means spreading risk; it is the well-established way of lowering systematic kets to be used in a diversified portfolio, it is necessary to check the historical simi-risk, and every investor is well advised to diversify. For the purposes of risk reduction, it is larity of equity patterns as well as consider the major forces that currently drive thenecessary to distinguish between systematic risk, which can be reduced by diversification, market—both historic and predictive sides of the problem. When properly selected,and market risk, which cannot be eliminated. The benefits of diversification are greatest diversification will reduce risk, as shown in Figure 23-6.when the markets traded are very different and the methods of making decisions are also 2. Multiple systems. Using more than one system will reduce risk, provided the sys-unrelated. Typical investment portfolios contain a variety of fixed income, equities, real tems are not similar. Techniques may appear different and yet be highly correlated.estate, art, as well as different investment philosophies, all intended to provide different ‘A moving average system, ARIMA model, and point-and-figure are very differentrates of return with different patterns and not suffer losses all at the same time. Unfortu- methods, but ail are trend-following, If the sensitivity of all three systems is similarnately, this is not always the case. Market risk, including catastrophic risk, is not pre-. (as determined by the number of trades per year), the equity patterns will also bedictable, and can surprise even the best investors. Avoiding market risk is the subject of this similar. For system diversification, it is best to select strategies with different func-practical diversification con be impl d using a broad selection of ces tional attributes. For example, the following list gives systems that are likely to beractical diversification can be implemented using a broad selection of markets within less correlated and techniques within each method that tend to be different.
a Single tactical system, a selection of different trading strategies for one product, or a com-
bination of multiple systems and products. The objectives of diversification are: a. Trend-following (moving averages or point-and-figure)
b. Countertrend (stochastic or contrary opinion)
1. Lower daily risk due to the offsetting of losses in some markets and systems with c. Spreading (interdelivery, intercommodity, arbitrage, product)profits in others. d. Fundamental
2. Insure participation in major moves by continuously trading those markets in var- All four techniques are very different. Fundamentals may be trending in naturejous groups that are likely to reflect fundamental changes. This avoids the need to but should have a longer time perspective. The four types of spreads all offer excel-
identify which market will perform the best. lent diversification.
3. Offset unexpected losses caused by a system failing to perform in the current mar- 3. Balanced risk. Equalizing risk is necessary if the selection of different commoditiesket, or a single trade that generates a large loss. It may be only bad luck that one sys- and systems is to offer proper diversification. Traditionally, price volatility or markettem gave a short signal in coffee the day before the freeze that moved prices limit-up