It's often said that traders and entrepreneurs share many of the same characteristics. The fact that both groups at times wear many hats is a big reason why.
For traders, one of the most important "hats" is that of the risk manager.
While the thrill of identifying and deploying your best ideas may get you out of bed in the morning, it's the successful navigation of the trade lifecycle and risk management of your overall portfolio that often brings home the returns.
For those looking to hone their risk management skills, a recent episode of Options Jive may be of particular interest. Entitled "Common Risks in a Portfolio," this episode highlights several categories of risk that possess potential landmines traders need to be aware of.
The four specific risk areas outlined on the show include:
While you may already be aware of all the terms listed above, it's possible that a detailed review may assist you in optimizing your risk management approach.
Of the four, directional risk is the easiest one to visualize (and possibly correct). Directional risk speaks to the relative performance of your portfolio as the market goes up, compared to when it goes down.
It's entirely possible you may, at times, have a directional bias in your outlook for the market. However, it's equally important that you understand the risks of that posture, and the degree to which you are exposed.
On the show, the Options Jive team discusses the importance monitoring your portfolio's beta weighted delta.
A beta weighted delta closer to zero generally indicates that a portfolio's exposure to one direction or the other, is reduced.
Traders that find their portfolio is skewed too far in one direction can hedge that risk using underlying stock (i.e. a delta neutral approach) or by deploying new positions (going forward) that help balance out the directional bias of the portfolio.
Correlation risk represents a slightly different animal than directional risk. For example, take KRE and XLF, which are two highly correlated ETFs in the financial sector. Due to the high correlation, traders taking on similar positions in both products have effectively doubled down on the same bet.
The reasoning is founded in the close correlation between XLF and KRE (which has been about 0.90 in recent months). If XLF starts moving a lot, it's probable that KRE will do so too - meaning your short premium positions in both could suffer.
To combat correlation risk, traders often review their portfolios periodically to ensure that a specific type of exposure hasn't gotten concentrated.
An analysis of correlation risk in your portfolio may also at times lead you back to directional risk. For example, if you believed hypothetically it was a good time to short XLE, then you probably wouldn't want to short XOP at the same time. XLE and XOP are highly correlated ETFs within the energy sector, so this would once again translate to doubling down.
The Options Jive team also discusses leverage risk and tail risk during the balance of the episode. For the best possible understanding of this material, we hope you’ll take the time to watch the complete episode of Options Jive focusing on portfolio risk when you schedule allows.
Risk in our portfolios is ever-changing, which is one reason that the risk manager “hat” is such an important part of being a trader.
Going forward, we hope you’ll reach out with any questions you might have pertaining to risk in your portfolio at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.