Author: goodalexander
Compiled by: TechFlow
Lesson 1: Understand the Maximum Drawdown of Your Overall Portfolio
The first step in risk management is to fully understand the maximum drawdown (Drawdown) that your investment portfolio may face. Specifically, it is recommended to organize all your investment exposures, convert them into a total return series, and analyze the drawdown situation in the following dimensions:
- A. The maximum drawdown from peak to trough (Peak to Trough Drawdown).
- B. The drawdown in individual trades, especially overnight drawdowns (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, and maintain neutrality.
It is recommended to analyze the drawdown data for the past 1 year and the past 10 years separately. However, some instruments in your portfolio may 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 tools 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 advantages of your strategy and only calculate the losses of the instruments themselves, not the losses 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 Exposures
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 Financial Markets (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 Exposures
In investing, factor exposure refers to the extent to which your investment portfolio is affected by certain market-specific factors. Here are some common factor exposures:
- Momentum: Focus on price trends, buy rising assets, and sell falling assets.
- Value: Invest in undervalued assets, such as stocks with low price-to-earnings ratios.
- Growth: Invest in assets with faster revenue or earnings growth.
- Carry: Invest in high-yielding assets by 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 in reality, this means that your strategy may tend to "chase the trend and kill the dip". This is particularly complex because in trend-following strategies, you may intentionally take on certain factor risks.
Some effective indicators for measuring factor exposures include:
- Average price Z-score (to measure the relative position of prices) for the non-trend-following part of the portfolio.
- Average price-to-earnings ratio (or equivalent metric) for the non-value part of the portfolio.
- Average revenue growth rate (or expense growth rate) for the non-growth part of the portfolio.
- Average portfolio yield (if your yields are in the mid-double-digit range, it may indicate that you are taking on higher carry factor risk).
In the cryptocurrency market, the trend factor often becomes ineffective as the market as a whole fluctuates, as too many investors use similar strategies, amplifying the potential risks. 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 Sizes Based on Implied Volatility, or Set Explicit Position Size Parameters for Different Market Environments
In risk management, using implied volatility (Implied Volatility) rather than realized volatility (Realized Volatility) to adjust position sizes 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 / Actual Volatility over the past 12 months) × Maximum Drawdown over the past 3 years = 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 day without a significant impact on the price.
If the market becomes illiquid, it may take you several days to fully unwind your positions. 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 assumption may seem conservative, it is very important in actual operations).
Lesson 6: Clearly 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 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. This type of risk is 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 over a multi-week timeframe. For example, during the "Taper Tantrum", the market had already been aware of the potential problems for interest-rate-sensitive assets. Similarly, many signs were already present before the COVID risk outbreak. By identifying these risks in advance, you can better protect your investment portfolio.
Lesson 7: Clearly Define Your Risk Limits Within the Risk Framework
Before making any investment or bet, you must clearly define the following key questions in advance:
- What is the specific content of the bet? You need to be clear about the core logic and goal 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 is unfavorable to 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 major losses and be prepared to respond.
Record the answers to these questions or track them in some way, which can help you manage risks more clearly.
Lesson 8: Reflection on your own risk management performance
In risk management, it is crucial to maintain a clear awareness of your own performance. If your reaction to reading this is "Haha, I won't do this" or "What does this have to do with me ordering a Wendy's burger?", then you may need to immediately reduce your risk by 1/3, or you should not have taken on these risks in the first place.
Remember, the menu prices at Wendy's are low and straightforward - if you treat the market like Wendy's, then your position size should also remain low-risk, rather than "betting" extravagantly like going to the Ritz Hotel.
Of course, I also understand that most people will not follow these recommendations completely. I fully understand that publishing this content may be futile, so you don't need to remind me of this point again.
