October 14, 2018

The New Paradigm in Risk Management is Direction Neutral

Almost everyone’s approach to trading/investing is forecasting price direction and calculating support and resistance for risk and reward.

This method looks at context first to judge risk and reward, based on market dynamics.

Here is what I mean by “direction neutral” and it does not matter if you trade mechanical strategies or trade a plan off visual indicators. The only difference is who (or what) is seeing the data stream.

To drive home the significance of this idea you need to contrast it to the industry benchmark. One of the pioneers of systems trading -Robert Pardo – in his original text said the following:

“Let us consider the plus side of the discretionary trader. It is quite simple. The biggest plus is that, to date, I do not believe that a systematic strategy has yet been created that equals, let alone exceeds, the performance of the greatest discretionary traders.”

I accept this as true that a robust trading system or plan will not make anyone rich, and that may be one of the reasons why you trade visually with discretion and not with systematic signals.

In other words, a trading plan or a system – at least the way Bob developed them – are statistically robust and in practice generic. They are designed to deal with all the major conditions in the markets going back over the longest period as possible. They are meant to provide the trader with an average winning trade each time he takes a position on a regular basis over the long term.

This goal of a trading plan or method is the heart and soul of the system trading school of thought that the industry is happy with and many traders do well at. Furthermore, it is likely your goal to make an average amount of money each day or week as supplemental income.

But as Bob says himself in so many words about system trading, it can be good, but not “GREAT.”   He goes on to point out the following:

“Proof of this concept is available by the mere consideration of a short list of some of the household names of the greatest discretionary traders. This short list of the greatest would include legendary billionaires such as George Soros, Paul Tudor Jones, Bruce Kovner, and T. Boone Pickens.”

You can’t argue with that, right?

One of the legends I study is Stanley Druckenmiller, and it is his notion of risk management that I set out to understand and replicate. As it turns out he did not have a corner on the idea, it goes back 100 years and in my lifetime cuts across all of the legends I am familiar with, that “the best risk management is not to take a risk at all.”

Traders like Jesse Livermore spoke about his first principle that big money is made by the sitting and the waiting, not the trading. Waiting until all the factors are in favor of his trading strategy before making the trade.

The modern-day hedge funds control risk by not taking a risk, but once everything is 100% correct based on their comprehensive system or trade plan checklist, they enter the markets and, in their words, “go for the jugular.” In other words, they leverage up and maximize profits.

It is easy to understand, once you cut through what the retail industry and the media publish every day, overlooking the above idea, ignoring or considering it trash. Our even seeing it regarding transactions or Vegas type of gambling, which is the opposite of taking no risk!

Everything the legends do is just the opposite of what the industry promotes, their idea of a trade plan. They only pay lip service to the great ones, when you think it through.  But once you take to heart what they say and what it means to implement you know it can’t be transactional or “you have to be in it to win it.”

The key rule of risk management is to avoid risk, do not take on a position until everything in your model is in your favor. A key rule of opportunity management is once you are in a position, you go for the gusto; you leverage up to maximize your profits.

To execute these two key rules, you need a strategy to get you in and out of the market profitably, the basic trade plan if you will. We have all seen strategies that work. There are many, hundreds of them that are sound.

Key number two is a governing model to tell you when to trade the strategy and when not to trade it.

Like I said above, “no one else talks about this method because no one else has my tools.” But I will rephrase because I assume others in the bastions of Wall Street and behind the boardroom walls on La Salle, that traders running hedge funds have a similar model.

Here is a Long Volatility Example

Regardless of how it is measured volatility reflects the difference between the market as we imagine it to be and the market that exists. It is that tension our model -TEM- seeks to measure its extremes and its outcomes.

If above-average performance is achieved moving between short and long volatility exposure, we will only attain that edge if we relentlessly search for nothing but the truth. Otherwise, the truth will find us through volatility.

Here is an example of waiting for the 100% set up. The overarching matrix of engagement is our Technical Event Model (TEM).

One reason why a few will ignore this idea is they doubt they will ever find a method that gives them 100% certainly before they get into the market.  This doubt is imbued into all interested parties no matter what side of the desk they are sitting. It is in every sales and marketing piece that hits the airways. The 100% certainly makes the point but in the real world mark it down to 99% or whatever level gives you supreme confidence.

These numbers to the left will make sense relative to the above approach using TEM. The annual results are from a short only breakout scalping system that implements the Turtle money management method. It is easy to see that the strategy had two good years 2008 and 2018, both high volatility years and both preceded by signals provided by TEM that the year

would be a high volatility one.

However, if you assume you have to “be in it to win it” trading the system blindly, it’s a long time between drinks and a little bit of a bumpy road. In the 14-year history, there is a $53,000 drawdown. So, if one uses negative thinking and assumes poor timing, then the drawdown is a certainly. Given the drawdown, a capital manager would need $1,000,000 in funds to have the risk limited to 5% +/-.

Again, taking every trade, you would expect to pick up at least one year in ten of $200,000 or a 20% return on the account. Now, what if you have a Macro Filter like TEM that tells you when to engage this long volatility strategy?

Going into 2018, TMT’s January 18 MarketMap™  suggested the use of this exact system.  Here is how the year to date would have performed after $32.00 a trade cost to achieve the $243,528.00.  The strategy has the filter embedded in the code and you can see it keeps the systems from trading from June through August. 

The first thing a risk manager will see is the loss in May, on a million-dollar account, is a palpable 1.6%.

However, the successful fund manager needs more than one opportunity a decade, isolating one or two a year would be adequate.

ContraryThinker’s job is to provide opportunities for its professional’s advisors and managers. For all the liquid markets on either side of the trade.

ContraryThinker is always looking for the truth, nothing but the truth.

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Great and Many Thanks,

Jack F. Cahn, CMT
A Thinking Man’s Trader Since 1989,
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