Risk Management When Trading Spreads

[spread'em]

I had a question for the more veteran spreaders out there - how do you approach risk management?

Usually I take longer term views when trading spreads and will usually take trades where the reward outweighs the risk, for example 1:1.5 risk:reward but of course each trade is unique. Once a level is reached (target or stop) the trade is closed. Pretty mechanical.

I know of some techniques which use stat-arb and in those cases the traders will often average in/average down positions. How does this approach work with regards to RM? Do you run stats that tell you your hit rate (say 70% winners, 10% scratch, 20% losses) and then work backwards from there tweaking certain variables?

 

[tommcginnis]

Expectancy: that is the magic word.
It doesn't have to be all Kelly or Van Tharpie or even my personal fav. Al Sherbin. But simply paying attention to the probabilities of the $$numbers you're considering, and you're half-way there. But you have to work with a reward and risk number that reflect the expected value of the position.

Sometimes, a cost-or-price is 100% known. Then that part of the story is over: it's 100% of whatever that cost (long stock? long vertical spread?) was. Maybe you *sold* a vertical spread -- your received price (in 'premium') is alllllll that you're going to get.

But when you don't know part of the equation, DO NOT simply throw an unqualified target at the expectancy calc.

Sorry. Closing minutes of the Super Bowl. Pretty good game so far, but trying to prep for Monday, too. And I don't think I did a good job here.

 

[Neuroway]

I had a question for the more veteran spreaders out there - how do you approach risk management?

Usually I take longer term views when trading spreads and will usually take trades where the reward outweighs the risk, for example 1:1.5 risk:reward but of course each trade is unique. Once a level is reached (target or stop) the trade is closed. Pretty mechanical.

I know of some techniques which use stat-arb and in those cases the traders will often average in/average down positions. How does this approach work with regards to RM? Do you run stats that tell you your hit rate (say 70% winners, 10% scratch, 20% losses) and then work backwards from there tweaking certain variables?

I view any trading system as a car. Leverage is the gas pedal, stop losses are the breaks, the balance between regression to the mean / trend following is the steering wheel, capital is the gas, the speedometer marks the % gain / period ... and risk management is the speed you want to keep the thing at. Of course, the faster you go, the more risky it gets.

For me, a trading system that works must be able to ride the market whatever it's trending or not, by automatically (or semi-automatically) balancing itself between trend following and mean reversion.

If your trading system works, it works. It may be a big fat slow gas guzzling, underpowered SUV or a hyper-nervous 2,000 HP Lamborghini, it's all the same. It'll take more gas (capital) to operate a SUV from point A to point B, but eventually, it'll take you there. A Lamborghini will take you as fast as you want from A to B, if you don't crash it or be caught by the cops first...

So... The trick is leveraging your cage to a state where you feel perfectably comfortable at the wheel. Well... Perhaps a bit awaken if you like adrenaline and need something more than a comfy, slow ride. You can adjust leverage as often as you wish, just like the gas pedal of a vehicle.

 

[spread'em]

Thanks to a degree...I mean I know how to manage risk from various points of view (worked on a MM desk and traded spreads) so not really looking for any hints or tips per say so no need to be so allusive and mysterious in your answers...

I'm more looking to understand how the other side manage risk, those who trade mean reversion/stat-arb spreads. I understand that averaging in is common, but would like to know how it is approached. For example, if you are trading in a 5 tick range, how do you determine your stop? Do you use VaR or something like that to measure the odds of a 2/3 StD move against you and use those odds to work back towards what your R:R should be? I'm just curious as I've never really traded from that POV.

 

[mfocus]

I am looking for more info in this area as well. I got my backside spanked in trading naked put options on ES and the recent XIV fiasco. I dabbed in a couple of futures spreads on and off but I am looking at this more seriously.

I suppose using a sort of a stop based on STD or historical price behavior and time to expiry. The risk I see in trading futures spreads is the liquidity. In abnormal situations (as I have learned), the bid and ask may be wide and the closing out the position may be much more costly than anticipated leading to a hesitation of eating a big loss.

I also curious how the pro futures spreads traders handle risks.

Perhaps setting a hard stop may mitigate the risks, however, at times when liquidity is poor, positions may get closed out unexpectedly.

 

[i960]

I am looking for more info in this area as well. I got my backside spanked in trading naked put options on ES and the recent XIV fiasco. I dabbed in a couple of futures spreads on and off but I am looking at this more seriously.

Are you interested in this because you've been taught a lesson that there's not actually any free money in the market and want to transition to something you perceive as being less risky or just another source of perceived free money? Examine your motivations IMO.

I'm more looking to understand how the other side manage risk, those who trade mean reversion/stat-arb spreads. I understand that averaging in is common, but would like to know how it is approached. For example, if you are trading in a 5 tick range, how do you determine your stop? Do you use VaR or something like that to measure the odds of a 2/3 StD move against you and use those odds to work back towards what your R:R should be? I'm just curious as I've never really traded from that POV.

Check some of @s0mmi 's stuff as I'm sure he's gone over this, but afaik the people who are trading this way are taking lots of small-medium wins and then taking the occasional beat downs hoping to net out in the green regardless.

 

[mfocus]

Are you interested in this because you've been taught a lesson that there's not actually any free money in the market and want to transition to something you perceive as being less risky or just another source of perceived free money? Examine your motivations IMO.

I came to realize there is no free money in the market and most of my trading is directional without any hedging. Anything that is naked or unhedged is a red alert from now on. ES time decay and XIV roll requires one to be constantly invested and exposed in the market to make money with no hedges (or perhaps I do not have the knowledge to construct hedges for these products). Spreads offers a way to have a hedge rather than being naked to manage the downside risks?

 

[i960]

Definitely not. Spreads are trading the curve of an instrument. They are not hedged per se, so much as in they protect you from adverse moves that would happen anyway (although they do filter out some externalities at times). It's still a directional trade in some form or fashion otherwise there would be zero money to be made. This goes for everything.

The reason people got killed with XIV, ES puts, whatever is they were inherently positioned short vol (and in many cases not delta hedge hence also exposed to delta risk) at extremely low levels of vol coupled with a non-stop market runup. The correct trade there was to simply stop being short vol and either switch to long vol or stop making those trades entirely. Timing IS alpha.

 

[mfocus]

Definitely not. Spreads are trading the curve of an instrument. They are not hedged per se, so much as in they protect you from adverse moves that would happen anyway (although they do filter out some externalities at times). It's still a directional trade in some form or fashion otherwise there would be zero money to be made. This goes for everything.

Thanks! Timing IS alpha quote is golden. I wrote it down on a sticky on my monitor immediately

Understood, spreads basically trades on curve steepen or flatten basis. It does not block out the blow outs, however, I also noticed a quite a few proponents of spreads trading that the if there is a blow out, which will definitely happen over the course of one's trading career, the damage may be lesser than an outright. Capital preservation is the key to survival. While spreads may not be the solution, any incremental protection helps. Having taken a big drawdown on my trading account, I am acutely sensitive on the issue of capital preservation, hence my interest in spreads (and hedged trading) as opposed to naked.

The reason people got killed with XIV, ES puts, whatever is they were inherently positioned short vol (and in many cases not delta hedge hence also exposed to delta risk) at extremely low levels of vol coupled with a non-stop market runup. The correct trade there was to simply stop being short vol and either switch to long vol or stop making those trades entirely. Timing IS alpha.

Trading a theta decay strategy means constantly vested in the markets to make money, given the low vol environment and the need to scale up the risk ladder for returns, it makes one blinded or discount the abnormal movements in the overall markets. Which leads me to spreads as a method of trading, waiting for opportunity or timing for alpha instead of being naked for money.