Hedge Fund Market Wizard
Michael Plat: The Art & Science of Risk Control
Risk control is one of the most important factors for successful trading and Michael Plat masters that art. Risk management begins with trade implementation.
Expecting that interest rates will decrease; Platt will affirm a trading theme in a way that minimizes risk compared to the same return potential. Thus, he rarely implements directional trades as absolute long or short positions. Plat usually trades long options or complex spread structures that provide the same return, but with restricted risk.
In spite of limiting loss, Platt gets out of a trade if he feels uncomfortable. He also sets a time limit for his trades. If a trade doesn't work within a logical time, he just liquidates it.
A 3% loss is enough to accelerate a 50% reduction in a trader’s funding. This strict rule helps to prevent a trader from losing more than 5% of his initial stake.
The key is that this risk rule pertains to a trader’s opening stake. Thus, it motivates traders to be very careful at the beginning, being highly selective in their trades and tightly curbing the loss. As traders move ahead, their cushion widens because their trading profit enhances the preliminary 3% loss allowance.
Practically, the trader allocation risk control strategy ensures capital protection, while at the same time keeping upside potential open-ended. Effectively, it is an asymmetric risk management strategy.
Risk control is important for many reasons, like avoiding abnormal losses, minimizing emotional distress, and restricting the adverse impact of compounding. Large percentage losses require significantly greater percentage profits to breakeven- If you lose 50% of your capital, you will require a 100% profit to reach the old levels Losing trades creates a mental constraint for the trader and often results in missed winning trade opportunities.
According to Platt, trading follows the 80/20 rule. 80% of a trader’s profits comes from 20% of the trades. If the psychological side-effect of a loss results in missing a trade in the 20%, it can be a big deal.
Platt is very attentive towards the market response to the news. He refers to an intriguing observation in which there was a stream of adverse news, negative for his position. However, the market did not move against him. Platt was able to infer the market's inability to respond to the news. This was a confirmation of his trade idea and he increased his position four times. It turned out to be one of his biggest wins ever.