Effective risk management in a trading operation is as important as the signals that motivate the trades. A well-designed and executed risk management function is key to sustainable profitability in all organizations. This chapter presents the leading approaches for managing risk in high-frequency trading operations that are compliant with Basel II risk management standards.
As with any business decision, the process of building a risk management system involves several distinct steps:
First, the overall organization-wide goals of risk management should be clearly defined.
Next, potential risk exposure should be measured for each proposed trading strategy and the overall portfolio of the trading operation.
Based on the goals and risk parameters determined in the two preceding steps, a risk management system is put in place to detect abnormal risk levels and to dynamically manage risk exposure.
The following sections in turn address each of these steps.
The primary objective of risk management is to limit potential losses. Competent and thorough risk management in a high-frequency setting is especially important, given that large-scale losses can mount quickly at the slightest shift in behavior of trading strategies. The losses may be due to a wide range of events, such as unforeseen trading model shortcomings, market disruptions, acts of God (earthquakes, fire, etc.), compliance breaches, and similar adverse conditions.