If your reaction to point 8 is "Haha, I would never do these," then it's likely you need to immediately reduce your risk by 1/3.
Author: goodalexander
Compiled by: Deep Tide TechFlow
Lesson 1: Understand Your Portfolio's Maximum Drawdown
The first step in managing risk is to have a comprehensive understanding of the maximum drawdown your 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 across the following dimensions:
A. Maximum drawdown from peak to trough.
B. Drawdown in a single trade, especially overnight drawdown (Session Level Drawdown, which is particularly important in stock investments since you cannot sell overnight).
C. Daily drawdown.
D. Monthly drawdown.
When conducting these analyses, do not consider any specific market factors; maintain neutrality.
It is advisable to analyze 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. This can be addressed by establishing a return matrix and selecting proxy instruments. For example, for tools like Hyperliquid with a shorter history, you can choose XRP as a proxy since its historical data dates back to 2015.
In investing or trading, an important question 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 markets often break through historical data limits.
Maximum Drawdown = Max (3 times the maximum loss in the past year, 1.5 times the maximum loss in the past 10 years).
Another important reminder: when calculating these drawdowns, you need to exclude your strategic advantages and only calculate the losses of the instruments themselves, not based on drawdown losses.
A key metric for measuring the effectiveness of risk management is: the percentage of monthly profits relative to the maximum drawdown. In contrast, the Sharpe Ratio is not suitable for measuring actual risk because it does not reflect real scenarios (for example, whether you would collapse and switch to accounting due to significant losses).
Lesson 2: Understand Your Key Market Beta Exposures
In risk management, understanding the correlation of your portfolio with the market (i.e., Beta exposure) is crucial. Here are some typical categories of market Beta exposures:
Traditional Financial Markets (TradFi):
S&P 500 Index (S&P 500, code: SPY)
Russell 2000 Index (Russell 2000, code: IWM)
Nasdaq Index (Nasdaq, code: QQQ)
Oil (Oil, code: USO)
Gold (Gold, code: GLD)
China Market Index (code: FXI)
Europe Market Index (code: VGK)
Dollar Index (Dollar Index, code: DXY)
U.S. Treasuries (Treasuries, code: IEF)
Cryptocurrency Markets (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. Typically, the most effective way is to use futures instruments, as they have lower financing costs and smaller balance sheet requirements.
Simple Rule: Be clear about all your risks. If there are uncertain risks, try to hedge against them.
Lesson 3: Understand Your Key Factor Exposures
In investing, factor exposure refers to the degree to which your portfolio is influenced by certain market-specific factors. Here are some common factor exposures:
Momentum Factor: Focus on price trends, buying rising assets, and selling falling assets.
Value Factor: Invest in undervalued assets, such as stocks with low price-to-earnings ratios.
Growth Factor: Invest in assets with rapid income or profit growth.
Carry Factor: Invest in high-yield assets through low-cost financing.
These factors can be difficult to capture in practice. For example, you can capture the momentum factor of the S&P 500 through ETFs (like MTUM), but this may mean your strategy tends to "buy high and sell low." This is particularly complex because, in trend strategies, you may intentionally take on certain factor risks.
Some effective metrics for measuring factor exposure include:
Average price Z-score of the non-trend strategy portion (measuring the relative position of prices).
Average price-to-earnings ratio (or equivalent metric) of the non-value strategy portion.
Average income growth rate (or expense growth rate) of the non-growth strategy portion.
Average yield of the portfolio (if your yield is in the mid-double-digit range, it may indicate you are taking on higher carry factor risk).
In the cryptocurrency market, trend factors often fail with overall market volatility, as too many investors use similar strategies, leading to amplified potential risks. In the forex market, yield strategies (like carry trading) also face similar issues; the higher the yield, the greater the potential risk.
Lesson 4: Adjust Position Size Based on Implied Volatility or Set Clear Position Size Parameters for Different Market Environments
In risk management, using implied volatility rather than realized volatility to adjust position size can better address market uncertainty. For example, implied volatility often more accurately reflects market expectations when earnings reports are released or elections are approaching.
A simple adjustment formula is: (Implied Volatility / Realized Volatility over the past 12 months) × Maximum Drawdown over the past 3 years = Assumed Maximum Drawdown for each instrument.
Based on this formula, set clear maximum drawdown limits for each instrument. If an instrument lacks implied volatility data, it may indicate insufficient liquidity, which requires special attention.
Lesson 5: Beware of Cost Impacts from Insufficient Liquidity (Liquidity Risk)
In less liquid markets, trading costs can significantly increase. A basic principle is: never assume you can sell more than 1% of the daily trading volume in a day without significantly impacting the price.
If the market becomes illiquid, it may take you several days to fully liquidate your position. For example, if your position accounts for 10% of the day's trading volume, it may take 10 days to complete the liquidation. To avoid this, it is advisable to avoid holding positions exceeding 1% of the daily trading volume. If you must exceed this ratio, when modeling maximum losses, it is recommended to assume that for every 1% increase in the maximum drawdown of the instrument, the risk doubles (although this may seem conservative, this assumption is very important in practice).
Lesson 6: Clearly Identify "The Only Risk That Could Cause My Collapse" and Conduct Qualitative Risk Management
While the above methods are primarily quantitative analyses, risk management also requires qualitative forward-looking judgments. At any time, our portfolio may face hidden factor exposures. For example, investors currently holding long positions in USDCAD may face risks related to Trump tariffs. Such risks are often not captured by historical volatility due to the rapid changes in news events.
A good risk management habit is to regularly ask yourself: "What is the only thing that could cause my collapse?"
If you find that your positions are unrelated to certain potential risks, such as the USDCAD position's connection to Trump tariffs, consider hedging these risks through relative value trading (such as investing in Mexican stocks instead of U.S. stocks).
In fact, most significant historical losses are not particularly surprising over a multi-week timeframe. For example, during the "Taper Tantrum," the market had already recognized that interest-sensitive assets might face issues. Similarly, many signs had emerged before the COVID risk outbreak. By identifying these risks in advance, you can better protect your portfolio.
Lesson 7: Clearly Define Your Risk Limits in the Risk Framework
Before making any investments or bets, it is essential to clarify the following key questions in advance:
What exactly are you betting on? You need to be clear about the core logic and objectives of this trade.
How much loss are you willing to bear? Set an acceptable loss range in advance to avoid emotional decision-making.
How will you reduce market exposure? If the market moves against you, do you have sufficient strategies to control risk?
Can you exit the trade in a timely manner? If the trade goes against you, can you quickly close your position? Do you need to reduce your position size in advance?
What is the worst-case scenario? Identify risk factors that could lead to significant losses and prepare accordingly.
Document the answers to these questions or track them in some way to help you manage risk more clearly.
Lesson 8: Reflect on Your Risk Management Performance
In risk management, maintaining a clear awareness of your performance is crucial. If your reaction to this point is "Haha, I would never do these" or "What does this have to do with me ordering a burger from Wendy's," then it's likely you need to immediately reduce your risk by 1/3, or you shouldn't have taken on these risks in the first place.
Remember, Wendy's menu is inexpensive and straightforward—if you treat the market like Wendy's, then your position size should also remain low-risk, rather than extravagantly "betting" like you would at the Ritz.
Of course, I also understand that most people will not follow these suggestions completely. I fully recognize that publishing this content may be in vain, so you don't need to remind me of that.
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