What can retail traders learn by analyzing how hedge funds manage risk?

Bob Iaccino , Chief Market Strategist and Co-Founder of Path Trading Partners, joins us live every Friday from 11am EST, as our risk management educator.

With 30 years’ experience working as an active investor in equities, commodities, futures and FX there are few better to talk on the subject of risk management.

Bob has developed a method for breaking down his key fundamentals of risk management, in a way that he thinks retail traders can understand and use to get actionable insights to bring into their own trading.

Below are some excerpts of Bob’s thoughts from a recent live session.

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Let’s move into questions:

How well do you think retail traders manage their risk?

If I had to rank retail traders, overall, on a scale of 1 – 5, I would give them a 1 or maybe a 2.

It’s because they’ll say things like: ‘I’m going to take a particular position, and this is the amount of money I’m willing to lose in that position’. And if they feel more confident in a position they’ll risk more and if they feel less confident, they’ll risk less dollars.

The reason I feel that doesn’t work is because as a retail trader the first thing you need to be able to understand is where your position is wrong.

If a trader says: ‘I’m going to lose this amount of money on this trade – when it hits here, I’ll get out’. That doesn’t generally match up with the: volatility, average daily change, or rate of change of that particular asset. You need to look at the asset and see what the average volatility or daily range is and then see If your trade allows you to be within that range and not exceed it.

How well do hedge funds manage risk in comparison to retail?

If I’d give retail traders a high 1 or a low 2 on a scale of 1 to 5, I’d give hedge fund managers a high 2 or a low 3 - they’re not a 5 anymore. 10 or 15 years ago I’d have given them a 5.

What are some of their standard risk management processes?

Well, they tend to split up strategies and split up asset classes and allocate amounts of money to those different asset classes as per their overall fundamental views.

We did a session where we showed the different conditions that markets can be in, and which sectors outperform in those conditions.

A hedge fund will shift as their analysis of the type of market we’re in changes.

Where could a hedge fund improve on its risk management?

I’d first like to see them improve on their public and media impression of what a hedge fund is and then go back to their roots.

If you take someone like Bernie Madoff, his Ponzi scheme was enabled by the fact that hedge funds had stopped actually hedging and started trading. Hedge funds could improve by actually hedging again. Hedge funds have blown up because they’ve stopped hedging. They can improve by going back to their roots, taking core positions, and hedging them.

What methods or tools could retail traders adopt from hedge funds to improve their risk management process?

There are two key answers to this and the first is to trade in percentages and not in dollars. If you ever hear anyone interview, for example, someone like Stanley Druckenmiller, they will tell you how much the fund is up by percentage, not by money. That’s because the amount they’re up in terms of dollars doesn’t matter.

The second thing is diversification of assets within single strategies. I say that because if you have a strategy that operates well on multiple assets, they all have market conditions that are favorable for the strategy.

Every strategy has market conditions that are favorable for the strategy and unfavorable for the strategy. Asset classes go in different cycles at different times. So, maybe you’re trading the ‘SPY’ and it’s not doing so well but maybe the ‘GLD’ ETF is doing better.

You have to stick to one or two strategies and then diversify them across asset classes.

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