Monday, June 08, 2009

Managing Risk Late in the Trading Day

If you click on the chart of the S&P 500 e-mini contract (ES; 10 minute), you'll see the pattern of trade that has become commonplace: reasonably busy trade in the first hour, trade slowing down through the early afternoon, and then furious business being done in the last hour.

Notice the expansion of volume late in the day; about twice as many contracts traded per 10-minute period late in the day versus early in the first trading hour. Note also how volume is correlated with volatility: the morning range was 10 points; most of the 10-minute bars late in the day covered 5-7 points. We moved 13 points in a half hour--and then promptly dropped about 10 points within the next half hour.

What I'm hearing from some traders is that, in the heat of late-day excitement, they are actually raising their position sizing as the markets start to move. The combination of increased market volatility and increased position size creates an exponential rise in the volatility of the traders' profits and losses. Not only is it possible to wipe out a day's profits within a few minutes when sizing positions larger as markets become more volatile; it is possible to dig a hole so deep that entire trading accounts are jeopardized.

Remember my principle: when we increase the volatility of our P/L, we increase our emotional volatility. Under conditions of outsize winners and losers, our excitement, overconfidence, frustration, fear, and loss can color our decision-making, generating trading slumps. One of the worst things traders can do is traumatize themselves by failing to manage risk. You know the old Wall Street saying: there are old traders and there are bold traders, but not very many old, bold traders.

Of all the "therapy" approaches, risk management is the best, because it is wholly preventive.