Hedging Options

Managing the performance of your trading account must go beyond the discipline of money management. While money management remains critical, it is a subset of the total picture of managing your trading account’s profit and loss.That total picture is what Kenneth L. Grant aptly paints in his book, Trading Risk.  Total performance management of trading must treat the profit and losses in a trading account at 2 levels – the portfolio level and at the individual trade level. Kenneth L. Grant is Cheyne Capital’s Global Risk Manager and notable pioneer in designing risk control and capital allocation programs for global hedge funds.  Typically with most literature on risk management, you would expect complex numerical formulas beyond the reach of most retail traders who do not have a mathematical background.  Kenneth writes in a style that does emphasize the robustness of arithmetical reasoning, but helps you visualize the various types of risks with ample graphs. The content is not so numerically oriented that it is beyond the grasp of anyone who is comfortable with Statistics 101.There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 244 pages in total, excluding appendices.Chapter 1:  The Risk Management Investment.  18,  7.38%.Chapter 2:  Setting Performance Objectives.  18,  7.38%.Chapter 3:  Understanding the Profit/Loss Patterns over Time.  44,  18.03%.Chapter 4:  The Risk Components of an Individual Portfolio.  28,  11.48%.Chapter 5:  Setting Appropriate Exposure Levels (Rule 1).  24,  9.84%.Chapter 6:  Adjusting Portfolio Exposure (Rule 2).  22,  9.02%.Chapter 7:  The Risk Components of an Individual Trade.  58,  23.77%.Chapter 8:  Bringing It on Home.  32,  13.11%.Focus on chapters 2, 3, 4 and 7, which makes up about 61% of the book. These chapters are relevant for practical trading purposes.  Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective. Chapter 2: Setting Performance Objectives. There are 3 types of targets to set at the portfolio level.

Chapter 3: Understanding the Profit/Loss Patterns over Time. This chapter evaluates the profit and loss in terms of Time Units (typically day and week) feeding into Time Spans, Average Profit versus Average Loss, Standard Deviation, Sharpe Ratio, Median P/L, Percentage of Winning Days versus Losing Days, Drawdown and Correlation Analysis. This section focuses on the core metrics of trade performance, for a given period:

In calculating the metrics, it becomes clear if your strengths are in trading long debit spreads, short credit spreads, directional trades (be it up/down) or non-directional trades. Trade in line with what you are intuitively profitable at, be that debit/credit spreads or directional/non-directional trades. The metrics help you guard against trading counter-intuitively in opposition to your strengths. Chapter 4: The Risk Components of an Individual Portfolio. The emphasis of this chapter is on Historical Volatility, Correlation and Implied Volatility and Value at Risk (VaR). While it is educational to understand how these various risks can be aggregated up into a single, portfolio measure of exposure, it is not useful for option traders trading retail portfolios from home.  Why?  To re-simulate the test scenarios on the portfolio cited in the text, requires specific types of data. The Account Statement of most retail option trading platforms only record each trade’s profit, loss and date. The additional data of each day’s Historical Volatility, Implied Volatility, Correlation coefficient values and Standard Deviation/Variance values will need to be sourced from outside the trading platform.  Unless you are trading multiple portfolios on behalf of other individuals, VaR simulations make sense. If you are trading just your own portfolio, it more useful to get an Implied Volatility tool that forecasts IV rising or falling by X% over 30-60-90-120 days.  This is a much more affordable way to assess the total impact of IV and Correlation in IV on your portfolio.Chapter 7: The Risk Components of an Individual Trade. The section to focus on here is the Core Transaction-Level Statistics. This includes the Trade Level P/L, Holding Period, Average P/L, Weighted Average P/L, Average Holding Period, P/L by Security or Asset Class and Long Side P/L versus Short Side P/L.  The main point here is to monetize the Average Holding Period of a long or short position. For example, as a guideline:

In conclusion, the critical points to focus on are the 3 types of targets at the portfolio level, the core metrics of trade performance, identifying your intuitive trading orientation and monetizing the average holding period of long and short trades for efficient trade turnover.  Translating these specific elements of trading risk into methods you can rely on every day, builds the required consistency in the profit and loss of your trading account.