Four Key Elements of Risk Management in Trading and Investing – Introduction
William Ackman is one of the most famous investors of our time. He runs a hedge fund known as Pershing Square Capital Management, which invests in a handful of companies. After having a great year in 2014, Ackman was focused on continuing the winning streak. It was at this time that a former Harvard colleague introduced him to Valeant Pharmaceuticals. This was a company that specialized in acquiring other companies and improving shareholder value by hiking the prices of the drugs it bought. In the beginning, the stock price climbed and he was making a tidy profit. As the election campaign started to focus on the practices in the pharmaceutical industry, the company’s stock collapsed. In the end, Bill lost more than $4 billion. This is a major lesson on risk management and why it should matter to you as a trader. This article explains a few elements of a good risk management strategy.
If William Ackman had placed all his funds in Valeant Pharmaceuticals, his hedge fund would have collapsed. However, it did not collapse because he had other companies in his portfolio. The same is true for you as a trader. While some traders have become successful by trading single assets, it is often recommended to incorporate the concept of wise diversification. It should be wise because many traders often make the mistake of diversifying in the wrong way. For example, if you are short the EUR/USD and GBP/USD pairs, it means that you believe the dollar will be strong. However, this presents a risk if the dollar weakens. To hedge, a way you can do it is to be short the EUR/USD pair and then be long the GBP/USD pair.
Back-Testing and Stress-Testing
Back-testing is an important aspect in risk management. It involves using historical data to make decisions about the future. Stress-testing on the other hand aims to take extreme events to determine the potential losses and gains. These two approaches are very important because they will give you an indication of what will happen in your trades. Fortunately, these tools are built-in the modern-day trading systems, including those offered by DTTW.
This is important if you are a money manager for external clients. In the example of William Ackman above, it was impossible for his investors to sue him for his losses. This is because they signed an agreement when they invested in him. As a result, it is very important for you to have a signed agreement that you will use in case you make big losses. Such document will help you reduce the chances of legal action being taken against you.
This is a major issue that is very common with new traders. Instead of opening small trades that can turn out to be profitable, they open large trades with the goal of making more money. The challenge in this is that the loses are often so big that it makes it impossible to profit. In the example above, if Bill Ackman had opened a small investment, the losses would not have reached the magnitude that they reached.
Four Key Elements of Risk Management in Trading and Investing – UsefuTips
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