Author: goodalexander

Compiled by: TechFlow

Lesson 1: Understand the Maximum Drawdown of Your Overall Investment Portfolio

The first step in risk management is to fully understand the maximum drawdown your investment portfolio may face. Specifically, it is recommended to compile all your investment exposures, convert them into a total return series, and analyze the drawdown situation in the following dimensions:

A. Maximum drawdown from peak to trough (Peak to Trough Drawdown).

B. Drawdown within a single trade, especially overnight drawdown (Session Level Drawdown, which is particularly important in stock investments, as you cannot sell at night).

C. Daily Drawdown.

D. Monthly Drawdown.

When conducting these analyses, do not consider any specific market factors, maintain neutrality.

It is recommended to analyze the drawdown data for the past 1 year and the past 10 years separately. However, your portfolio may have some instruments that lack 10 years of historical price data. For this, you can solve the problem by establishing a return matrix and selecting proxy instruments. For example, for instruments with a shorter history like Hyperliquid, you can choose XRP as a proxy tool, as its historical data can be traced back to 2015.

An important question in investing or trading is: Is there a possibility of losses exceeding the expected range? You need to assume that the actual market volatility may exceed your simulated values, as the market often breaks through the limits of historical data.

Maximum Drawdown = Max (3 times the maximum loss in the past 1 year, 1.5 times the maximum loss in the past 10 years).

Another important reminder: when calculating these drawdowns, you need to exclude the advantage of your strategy and only calculate the loss of the instrument itself, not the loss based on the drawdown.

The key indicator for measuring the effectiveness of risk management is: the percentage of monthly profits to the maximum drawdown. In comparison, the Sharpe Ratio is not suitable for measuring actual risk, as it cannot reflect real-world scenarios (such as whether you will collapse and switch to accounting due to massive losses).

Lesson 2: Understand Your Key Market Beta Exposure

In risk management, understanding the correlation of your investment portfolio with the market (i.e., Beta exposure) is crucial. Here are some typical market Beta exposure categories:

Traditional Finance (TradFi):

• S&P 500 Index (SPY)

• Russell 2000 Index (IWM)

• Nasdaq Index (QQQ)

• Oil (USO)

• Gold (GLD)

• China Market Index (FXI)

• European Market Index (VGK)

• US Dollar Index (DXY)

• US Treasuries (IEF)

Cryptocurrency Market (Crypto):

• Ethereum (ETH)

• Bitcoin (BTC)

• Top 50 Altcoins (excluding ETH and BTC)

Most investment strategies do not have explicit market timing strategies for these market Beta exposures. Therefore, these risks should be minimized to zero. The most effective way is usually to use futures instruments, as they have lower financing costs and smaller balance sheet requirements.

Simple rule: Clearly understand all your risks. If there are uncertain risks, try to hedge them as much as possible.

Lesson 3: Understand Your Key Factor Exposure

In investing, factor exposure refers to the extent to which your investment portfolio is influenced by certain market-specific factors. Here are some common factor exposures:

• Momentum Factor: Focus on price trends, buy rising assets, and sell falling assets.

• Value Factor: Invest in undervalued assets, such as stocks with low price-to-earnings ratios.

• Growth Factor: Invest in assets with faster revenue or earnings growth.

• Carry Factor: Invest in high-yielding assets through low-cost financing.

These factors are difficult to capture in practice. For example, you can use ETFs (such as MTUM) to capture the momentum factor of the S&P 500, but this means your strategy may tend to "chase the trend and kill the dip." This is particularly complex because in trend strategies, you may intentionally take on some factor risks.

Some effective indicators for measuring factor exposure include:

• Average price Z-score of the non-trend strategy portion (to measure the relative position of the price).

• Average price-to-earnings ratio (or equivalent metric) of the non-value strategy portion.

• Average revenue growth rate (or expense growth rate) of the non-growth strategy portion.

• Average portfolio yield (if your yields are in the mid-double digits, it may indicate you are taking on higher carry factor risk).

In the cryptocurrency market, the trend factor often becomes ineffective as the market fluctuates overall, as too many investors use similar strategies, amplifying the potential risk. In the foreign exchange market, yield strategies (such as carry trades) also have similar issues, where the higher the yield, the greater the potential risk.

Lesson 4: Adjust Position Size Based on Implied Volatility, or Set Explicit Position Size Parameters for Different Market Environments

In risk management, using implied volatility (IV) rather than realized volatility (RV) to adjust position size can better address market uncertainties. For example, when earnings reports or elections are approaching, implied volatility is often better able to reflect market expectations.

A simple adjustment formula is: (Implied Volatility / Past 12-month Actual Volatility) × Past 3-year Maximum Drawdown = Assumed Maximum Drawdown for Each Instrument

Based on this formula, set a clear maximum drawdown limit for each instrument. If an instrument lacks implied volatility data, it may indicate insufficient liquidity, which requires special attention.

Lesson 5: Beware of the Cost Impact of Lack of Liquidity (Liquidity Risk)

In markets with poor liquidity, transaction costs can increase significantly. A basic principle is: never assume that you can sell more than 1% of the daily trading volume in a single day without a significant impact on the price.

If the market becomes illiquid, it may take you several days to fully unwind your position. For example, if your position accounts for 10% of the daily trading volume, it may take 10 days to complete the liquidation. To avoid this, it is recommended to avoid holding positions that exceed 1% of the daily trading volume. If you have to exceed this ratio, when modeling the maximum loss, it is recommended to assume that for every 1% increase in the instrument's maximum drawdown, the risk doubles (although this may seem conservative, this assumption is very important in actual operations).

Lesson 6: Identify the "Unique Risk That Could Cause My Collapse" and Conduct Qualitative Risk Management

Although the above methods are mainly quantitative analysis, risk management also requires qualitative forward-looking judgment. At any given time, our investment portfolio may face hidden factor exposures. For example, investors currently holding long USDCAD positions may face risks related to Trump's tariffs. These types of risks are usually difficult to capture through historical volatility, as news events change too quickly.

A good risk management habit is to regularly ask yourself, "What is the one thing that could cause me to collapse?"

If you find that the positions you hold are unrelated to certain potential risks, such as the USDCAD position being unrelated to Trump's tariffs, you can consider hedging these risks through relative value trades (such as investing in Mexican stocks instead of US stocks).

In fact, most major historical losses are not particularly surprising within a multi-week timeframe. For example, during the "Taper Tantrum" period, the market was already aware that interest rate-sensitive assets might encounter problems. Similarly, many signs had already emerged before the COVID risk outbreak. By identifying these risks in advance, you can better protect your portfolio.

Lesson 7: Clearly Define Your Risk Limits Within the Risk Framework

Before making any investments or bets, be sure to clearly address the following key questions in advance:

• What is the specific content of the bet? You need to be clear about the core logic and objectives of this transaction.

• How much loss are you willing to bear? Set an acceptable loss range in advance to avoid emotional decision-making.

• How to reduce market exposure? If the market trend is unfavorable, do you have enough strategies to control the risk?

• Can you exit the trade in time? If the trade goes against you, can you quickly close the position? Do you need to reduce the position size in advance?

• What is the worst-case scenario? Identify risk factors that could lead to significant losses and be prepared to respond.

Record the answers to these questions or track them in some way, which can help you manage risk more clearly.

Lesson 8: Reflection on Your Own Risk Management Performance

In risk management, maintaining a clear awareness of your own performance is crucial. If your reaction to reading this is "Haha, I won't do these things" or "What does this have to do with my Wendy's burger?", then you may need to immediately reduce your risk by 1/3, or you shouldn't have taken on these risks in the first place.

Remember, Wendy's menu prices are low and straightforward - if you treat the market like Wendy's, then your position size should also remain low-risk, rather than "betting" luxuriously like going to the Ritz Hotel.

Of course, I also understand that most people won't follow these recommendations completely. I fully understand that publishing this content may be futile, so you don't need to remind me of that again.