The Risk Challenge
Can you specify the risk in your positions?
- What is the worst thing that could happen? How much would you lose?
- How should you measure risk? Is it a question of daily volatility? What about absolute risk?
- You may have positions that seem uncorrelated to the market. The positions may even seem negatively correlated (think airlines and energy stocks) so that they offset each other. Could anything happen to change the relationship?
- Do you have a plan of action if something negative happens? Do you "fade the move" getting bigger, or do you stop out your positions taking a loss? Without an advance plan, it may be difficult to think clearly in a crisis situation.
- Does backtesting accurately reveal risk?
These are certainly not all of the questions, but they are important ones. Traders and investment managers who do not have good answers may find themselves facing a day of reckoning.