Posted on — October 3, 2014 8:34 pm (Australia/Sydney) | 7 Comments

There is a lot more access to funding programs and opportunities for retail traders to make the transition to managing money these days.

But if you do want to make the switch, the powers that will assess you will be looking very closely at your risk management, and sorry to say, the way you are doing it now is not likely to cut it.

The good news is that if you do understand the principles of hedge fund risk management, you will not find it difficult to adjust your trading to fit. You don’t need to master any fancy algorithms, you just need to know the right concepts so you can apply them – in this case knowledge truly is power.

If you are not interested in managing money, then you will still get a lot of value out of understanding how the elite world of hedge funds view Forex risk management… so don’t disappear yet.

Eliminate Wild Swings

I was discussing this topic with a with a friend of mine who is the principal trader for a hedge fund (who must remain unnamed at this point in time) and one of this comments that struck me was:

“If you drop 5% very quickly, you will be out the back door never to work again”

For a retail trader this may seem quite shocking. You have probably been taught its ok to risk 1 or even 2% of your account on a trade. If you do this then a rapid 5% drop is almost inevitable.

Instead if you are an institutional money manager, you would be trading much smaller sizes. Your core concern when managing risk is to remove volatility from your returns. To do this you would be risking less of your account per trade. For a short term trade this means you may only risk 0.1 to 0.25 % of your account. Or for a medium term trade you might risk only 0.5%.

For example, if the price goes against you and hits your stop-loss you would only lose 0.1 to 0.25% of your account. It’s important to note that this risk is irrespective of how far away your stop-loss is. If you have a 100 pip stop-loss you would lose the same as if you have a 10 pip stop-loss by adjusting the size of your position.

Use different ratios.

Further to the point above about limiting volatility, if you are looking to manage money your investors will look at your Sharp and Sortino ratios. These ratio’s measure your risk adjusted returns, which is of more interest to investors.

It’s the size of the drawdown relative to your profits that matters. I.e. smooth growth of your equity curve. One of the best ways to measure this is to use Jack Schwager’s Gain to Pain ratio (there’s some homework for you). Schwager’s ratio is good because it takes does not punish traders for large upside gains, like the more common Sharp ratio can.

A consistent 1% a month gain would put you in the top 10 funds globally

Did you know that if you were able to return a consistent 1% a month over the last 6 months or so, you would be in a top ten FX hedge funds in the world?

Of course, this 1% a month would need to come with very limited drawdowns.

Why would institutional investors be interested in 1% a month returns you ask?

It all comes down to leverage.

An institutional or high net worth investor will quite happily use leverage to turn that 1% a month return into 4% a month by applying leverage to the investment.

Can you see now why limited drawdowns are so important? If you are using leverage to boost returns you can’t afford to give money to a trader or fund that where you might wake up one morning and suddenly they are down 3%.

That 3% loss on 4 times leverage gives you a loss of 12%, and investors would go running for the hills if that happens.

This is a quick overview

There is a lot more to cover on this subject, so stay tuned for more.