Author: goodalexander

Compiled by: TechFlow

Lesson 1: Understand Your Total Portfolio Maximum Drawdown

The first step in managing risk is to fully understand the maximum drawdown your portfolio may face. Specifically, it is recommended to sort out all your investment exposures, convert them into total return series, and analyze the drawdowns in the following dimensions:

• A. Peak to Trough Drawdown.
• B. The extent of the drawdown in a single transaction, especially the overnight drawdown (Session Level Drawdown, overnight drawdown is particularly important in stock investment because you cannot sell at night).
• C. Daily Drawdown.
• D. Monthly Drawdown.

When performing these analyses, do not consider any specific market factor and remain neutral.

It is recommended to analyze the drawdown data for the past 1 year and the past 10 years respectively. However, there may be some instruments in your portfolio that lack 10 years of historical price data. This can be solved by building a return matrix and selecting a proxy instrument. For example, for an instrument with a shorter history such as Hyperliquid, XRP can be selected as a proxy instrument because its historical data can be traced back to 2015.

An important question in investing or trading is: Is there a possibility that the loss will exceed the expected range? You need to assume that the actual market fluctuations may exceed your simulation values, because the market often breaks through the limits of historical data.

Maximum drawdown = Max (3 times the maximum loss in the past year, 1.5 times the maximum loss in the past 10 years).

One more important note: when calculating these drawdowns, you need to remove your strategy advantage and only calculate the loss of the instrument itself, not the loss based on the drawdowns.

The key indicator for measuring the effectiveness of risk management is: the percentage of monthly profit to the maximum drawdown. In contrast, the Sharpe Ratio is not suitable for measuring actual risk because it does not reflect real scenarios (such as whether you will collapse and switch to accounting due to huge losses).

Lesson 2: Understand Your Key Market Beta Exposure

Understanding your portfolio’s correlation with the market (i.e., beta exposure) is critical in risk management. Here are some typical market beta exposure categories:

Traditional Financial Market (TradFi):

• S&P 500 (SPY)
• Russell 2000 Index (Russell 2000, Code: IWM)
• Nasdaq Index (QQQ)
• Crude Oil (USO)
• Gold (GLD)
• China Market Index (Ticker: FXI)
• European Market Index (Code: VGK)
• Dollar Index (DXY)
• U.S. Treasury Bonds (Treasuries, code: IEF)
• Cryptocurrency Market (Crypto):
• Ethereum (ETH)
• Bitcoin (BTC)
• Top 50 altcoins (excluding ETH and BTC)

Most investment strategies do not have explicit market timing strategies for these market beta exposures. Therefore, these risks should be minimized to zero. Often, the most efficient way to do this is to use futures instruments due to their lower funding costs and smaller balance sheet requirements.

Simple rule: Understand all your risks. If there is uncertainty, try to hedge it.

Lesson 3: Know Your Key Factor Exposures

In investing, factor exposure refers to the extent to which your portfolio is affected by certain market-specific factors. Here are some common factor exposures:

• Momentum factor: Pay attention to price trends, buy rising assets, and sell falling assets.
• Value factor: Investing in undervalued assets, such as stocks with low price-to-earnings ratios.
• Growth Factor: Investing in assets with faster growth in income or earnings.
• Carry factor: Investing in high-yield assets through low-cost financing.

These factors are harder to capture in practice. For example, you can capture the momentum factor of the S&P 500 through an ETF such as MTUM, but in practice this means that your strategy may tend to "chase the ups and sell the downs." This is particularly complicated because in a trend strategy, you may intentionally take on certain factor risks.

Some useful measures of factor exposure include:

• The average price Z-score (a measure of the relative position of prices) for the non-trending strategy portion.
• Average P/E ratio (or equivalent) of the non-value strategy segment.
• The average revenue growth rate (or expense growth rate) of the non-growth strategy segment.
• The average return of the portfolio (if your return is in the mid-double digit range, it may mean that you have a higher carry factor risk).

In the cryptocurrency market, trend factors tend to fail as the overall market fluctuates, because too many investors use similar strategies, resulting in amplified potential risks. In the foreign exchange market, income strategies (such as carry trades) also have similar problems. The higher the income, the greater the potential risk.

Lesson 4: Adjust position size based on implied volatility or set clear position sizing parameters for different market environments

In risk management, using implied volatility rather than realized volatility to adjust position size can better cope with market uncertainty. For example, when earnings reports are released or elections are approaching, implied volatility tends to more accurately reflect market expectations.

A simple adjustment formula is: (Implied Volatility / Realized Volatility in the Past 12 Months) × Maximum Drawdown in the Past 3 Years = Hypothetical Maximum Drawdown of Each Instrument

Based on this formula, set clear maximum drawdown limits for each instrument. If there is a lack of implied volatility data for a particular instrument, it may mean that it is illiquid, which requires special attention.

Lesson 5: Beware of the cost impact of insufficient liquidity (liquidity risk)

In less liquid markets, transaction costs can increase significantly. A general rule is to never assume that you can sell more than 1% of daily volume in a single day without significantly affecting the price.

If the market becomes illiquid, it may take several days to fully liquidate your position. For example, if you hold a position that represents 10% of the day's volume, it may take 10 days to liquidate. To avoid this, it is recommended to avoid holding positions that exceed 1% of daily volume. If you have to exceed this ratio, when modeling the maximum loss, it is recommended to assume that the risk doubles for every 1% increase in the instrument's maximum drawdown (although it may seem conservative, this assumption is very important in practice).

Lesson 6: Identify the “only risk that could break me” and conduct qualitative risk management

Although the above methods are mainly quantitative analysis, risk management also requires qualitative forward-looking judgment. At any time, our portfolio may be exposed to hidden factors. For example, investors who hold long positions in USDCAD now may be exposed to risks related to Trump's tariffs. Such risks are usually not captured by historical volatility because news events change too quickly.

A good risk management habit is to periodically ask yourself, “What is the only thing that could possibly cause me to go bankrupt?”

If you find yourself holding positions that are uncorrelated with certain potential risks, such as the correlation of USDCAD positions to Trump's tariffs, consider hedging these risks through relative value trades (such as investing in Mexican stocks instead of US stocks).

In fact, most of the major historical losses were not particularly surprising on a multi-week timeframe. For example, during the Taper Tantrum, the market was already aware that interest rate sensitive assets might have problems. Similarly, many signs of COVID risks were already evident before they occurred. By identifying these risks in advance, you can better protect your portfolio.

Lesson 7: Define your risk limits upfront in your risk framework

Before making any investment or bet, it is important to clarify the following key questions in advance:

• What exactly is the bet? You need to understand the core logic and objectives of the deal.
• How much are you willing to lose? Set an acceptable loss range in advance and avoid emotional decisions.
• How do you reduce your market exposure? Do you have adequate strategies to control risk if the market moves against you?
• Are you able to exit a trade in a timely manner? If a trade goes against you, can you close the position quickly? Do you need to reduce the size of your position in advance?
• What is the worst-case scenario? Identify risk factors that could lead to significant losses and prepare for them.

Writing down the answers to these questions or tracking them in some way can help you manage risk more clearly.

Lesson 8: Reflection on your risk management performance

In risk management, it is crucial to maintain a clear understanding of your performance. If your reaction to reading this is "Haha, I would never do this" or "What does this have to do with my ordering a Wendy's burger", then it is likely that you need to cut your risk by 1/3 immediately, or you should not take these risks in the first place.

Remember, the menu at Wendy’s is cheap and simple — if you treat the market like Wendy’s, then your position size should also be low risk, not an extravagant “bet” like going to the Ritz.

Of course, I also know that most people won't follow all of this advice. I fully understand that posting this is probably futile, so you don't need to remind me of that.