Traders's Notebook by Mike Carr, CMT, and Amber Hestia-Barnhart
How can individual traders manage risk?
Every successful trader learns to manage risk so they can avoid large losses like those that have crippled many Wall Street firms. In this article, we'll show how traders manage risk, identify the lessons we can learn from JPMorgan, and detail a way that technicians can duplicate the value at risk (VAR) metric that many large firms use to help add insight to their potential losses.
In what has become a fairly regular event, a Wall Street firm has announced a multibillion-dollar trading loss. JPMorgan told analysts and investors in early May that a hedge trade they had made would lead to a loss of at least $2 billion. CEO Jamie Dimon said that the firm "screwed up" and a number of mistakes allowed the loss to occur. He said that the trades were "riskier, more volatile, and less effective as an economic hedge than we thought." Individual traders face the same challenges with trades that don't always behave as expected and they generally use a number of techniques to minimize the chance of a large loss.
Individual traders have different motivations than institutional traders. Often, the individual is trying to make sure they have enough money for retirement or they may even depend on trading profits as their primary source of income.
In contrast, institutional traders have a base salary to cover their monthly expenses, and benefits often include a well-funded retirement plan. For them, trading increases their bonuses, which means they would be more aggressive than individual traders. Because of this, institutional traders may not use the simple risk management tools that an individual would.
FIVE SIMPLE RULES TO MANAGE RISK
Most individual traders diversify their investments, although this may not be possible for those trading smaller accounts. Even when diversification is impossible, the individual uses other risk management strategies to ensure their trading survival.
In the JPMorgan trade, the trader seemed to be concentrating his bets in a single derivatives market. In a Bloomberg News story about the loss, the wire service noted that it "first reported April 5 that [the trader in London at the center of the problem] had built positions that were so large he was driving price moves in the $10 trillion market for credit-swap indexes."