Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

TWO SCHOOLS OF PRICE RISK MANAGEMENT

Read enough books on trading and price risk management, and one may come to the erroneous conclusion that there are two distinct schools of price risk management: trader school and VaR/stress testing school. Although both schools sometimes imagine their theories regarding price risk management to be mutually exclusive, usually this is not the case. Furthermore, it is only through adaptation of the strengths of both approaches that a robust price risk management solution can be achieved.

One school dominates the books that have been written by and for traders. These books typically emphasize managing price risk based on two factors:

1. Volumetric price risk management, which is based on the size of the positions taken in the markets or how many volumetric units (e.g., contracts, shares, etc.) will be traded
2. Stop-loss price risk management, which determines the size of the risk assumed per position traded or how much capital will be risked per volumetric unit traded

The other school is composed primarily of risk management professionals and academicians who focus on price risk management on a portfolio-wide basis and utilize tools such as value at risk (VaR) and stress testing to aid in their development of a comprehensive price risk management strategy. VaR examines the standard deviation (or historical volatility) of a trading portfolio as well as the correlations between its various components. Stress testing attempts to illuminate weaknesses ...