How to manage risk control in trading during a market downturn?
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How to manage risk control in trading during a market downturn?
If your reaction to reading point 8 is "haha, I'd never do these things," then you likely need to immediately reduce your risks by one-third.
Navigating Web3 tides with focused insightsAuthor: goodalexander
Compiled by: TechFlow
Lesson One: Understand Your Portfolio's Maximum Drawdown
The first step in risk management is gaining a comprehensive understanding of your portfolio’s potential maximum drawdown. Specifically, compile all your investment exposures into a total return series and analyze the drawdown across the following dimensions:
A. Peak-to-trough drawdown magnitude.
B. Session-level drawdown, particularly overnight drawdown (especially critical in stock investing, as you cannot sell during nighttime).
C. Daily drawdown.
D. Monthly drawdown.
When conducting this analysis, do not consider any specific market factors—maintain neutrality.
It is recommended to analyze drawdown data over both the past 1 year and past 10 years. However, some instruments in your portfolio may lack 10 years of historical price data. In such cases, build a return matrix and use proxy instruments. For example, for newer platforms like Hyperliquid, XRP can serve as a proxy due to its available data since 2015.
An important question in investing or trading is: Is there a possibility of losses exceeding your expected range? Assume that actual market volatility could exceed your modeled estimates, as markets often break beyond historical patterns.
Maximum Drawdown = Max (3 × past 1-year maximum loss, 1.5 × past 10-year maximum loss).
One crucial reminder: when calculating these drawdowns, strip out your strategy edge—only assess the instrument’s inherent loss, not the loss based on your drawdown strategy.
A key metric for evaluating risk management effectiveness is: monthly profit as a percentage of maximum drawdown. In contrast, the Sharpe Ratio is unsuitable for measuring real-world risk, as it fails to reflect actual scenarios (for example, whether you’d collapse from large losses and switch careers to become an accountant).
Lesson Two: Understand Your Key Market Beta Exposures
In risk management, understanding your portfolio’s sensitivity to broader markets—its beta exposures—is essential. Below are typical categories of market beta exposures:
Traditional Finance (TradFi):
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S&P 500 Index (SPY)
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Russell 2000 Index (IWM)
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Nasdaq Index (QQQ)
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Oil (USO)
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Gold (GLD)
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China Market Index (FXI)
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European Market Index (VGK)
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Dollar Index (DXY)
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U.S. Treasuries (IEF)
Cryptocurrency Markets (Crypto):
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Ethereum (ETH)
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Bitcoin (BTC)
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Top 50 altcoins (excluding ETH and BTC)
Most investment strategies do not have explicit market timing mechanisms for these beta exposures. Therefore, such risks should be minimized to zero whenever possible. Futures are typically the most efficient instruments for hedging, given their low funding costs and minimal balance sheet impact.
Simple rule: Know all your risks clearly. If any exposure is uncertain, hedge it.
Lesson Three: Understand Your Key Factor Exposures
In investing, factor exposure refers to how sensitive your portfolio is to certain systematic market factors. Common factor exposures include:
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Momentum: Focuses on price trends—buying rising assets and selling falling ones.
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Value: Investing in undervalued assets, such as stocks with low P/E ratios.
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Growth: Investing in assets with fast-growing revenue or earnings.
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Carry: Funding at low cost to invest in high-yielding assets.
These factors are difficult to capture effectively in practice. For instance, while you might use ETFs like MTUM to capture S&P 500 momentum, this may lead your strategy to inherently "chase performance." This becomes especially complex in trend-following strategies where you may intentionally take on certain factor risks.
Useful metrics for measuring factor exposures include:
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Average price Z-score outside trend-based strategies (measures relative price positioning).
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Average P/E ratio (or equivalent) outside value strategies.
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Average revenue growth rate (or fee growth) outside growth strategies.
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Portfolio average yield (if your yields are in the mid-teens or higher, you may be taking significant carry risk).
In crypto markets, trend factors often fail during broad market moves because too many participants follow similar strategies, amplifying latent risks. Similarly, in FX markets, high-yield strategies (like carry trades) exhibit the same issue—the higher the yield, the greater the hidden risk.
Lesson Four: Size Positions Based on Implied Volatility, or Set Explicit Position Parameters for Different Market Regimes
In risk management, using implied volatility (IV) instead of realized volatility allows better adaptation to uncertainty. For example, around events like earnings reports or elections, IV often more accurately reflects market expectations.
A simple sizing formula: (Implied Volatility / Past 12-month Realized Volatility) × Past 3-year Maximum Drawdown = Assumed Maximum Drawdown per Instrument
Set clear maximum drawdown limits for each instrument based on this formula. If an instrument lacks implied volatility data, it likely has poor liquidity—this requires special caution.
Lesson Five: Beware of Cost Impact from Low Liquidity (Liquidity Risk)
In illiquid markets, transaction costs can rise significantly. A basic principle: never assume you can sell more than 1% of an asset’s daily volume in a single day without materially impacting the price.
If a market turns illiquid, unwinding a position may take days. For example, if your position equals 10% of daily volume, full exit might take 10 days. To avoid this, avoid holding positions larger than 1% of daily volume. If you must exceed this threshold, model your maximum loss assuming that every 1% increase in drawdown doubles your risk (this may seem conservative, but such assumptions are vital in practice).
Lesson Six: Identify the “One Thing That Could Break You” and Apply Qualitative Risk Management
While the above methods are quantitative, risk management also requires qualitative, forward-looking judgment. At any time, hidden factor exposures may lurk in your portfolio. For example, being long USDCAD today may expose you to risks related to Trump-era tariffs—risks not captured by historical volatility due to rapid news cycles.
A strong risk habit is to regularly ask yourself: “What is the one thing that could break me?”
If you find your positions exposed to such latent risks—for example, USDCAD linked to U.S.-Canada trade policy—consider hedging via relative value trades (e.g., overweight Mexican equities vs. U.S. equities).
In reality, most major historical losses were not surprising over multi-week horizons. For example, before the “Taper Tantrum,” markets already sensed trouble in rate-sensitive assets. Similarly, pre-COVID signals were visible. Proactively identifying such risks helps protect your portfolio.
Lesson Seven: Predefine Risk Limits Within Your Risk Framework
Before making any investment or bet, clearly define the following questions in advance:
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What exactly are you betting on? Be clear about the core logic and objective of the trade.
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How much loss are you willing to accept? Set predefined loss boundaries to prevent emotional decisions.
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How will you reduce market exposure? If the market moves against you, do you have a plan to manage risk?
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Can you exit promptly? If the trade turns against you, can you close quickly? Should you scale down early?
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What’s the worst-case scenario? Identify key risk drivers and prepare accordingly.
Document these answers or track them systematically to maintain clarity in risk management.
Lesson Eight: Reflect on Your Own Risk Management Performance
In risk management, maintaining honest self-awareness is crucial. If your reaction upon reading this is “Ha, I’d never do any of this” or “What does this have to do with my Wendy’s burger order?”, then you likely need to cut your risk by 1/3 immediately—or perhaps you shouldn’t be taking such risks at all.
Remember, Wendy’s menu is cheap and straightforward—if you treat the market like a visit to Wendy’s, your position sizes should remain low-risk, not like placing extravagant bets at the Ritz.
Of course, I know most people won’t fully follow this advice. I fully understand publishing this might be futile—so no need to remind me.
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@goodalexander
