Risk Management — The Framework That Keeps the Journal in the Game

Risk management is the framework that determines whether the journal survives long enough for the edges to play out. A trader with a good methodology but bad risk management will eventually be wiped out by a single large loss; a trader with a mediocre methodology but good risk management will still be in the game when the methodology improves. The journal's risk management framework is built around three limits: position-level risk, portfolio-level risk, and drawdown limits.

Position-level risk

Position-level risk is the max-loss of a single position expressed as a percentage of NLV. The journal's rule is that no single position may risk more than 2% of NLV at the time of entry. The rule is mechanical, not discretionary — once the structure is chosen, the size is set by the structure's max-loss divided by 0.02 × NLV.

The 2% rule has a few exceptions:

1. The iron butterfly is sized to 1% of NLV rather than 2%. The iron butterfly's high probability of profit is offset by the fact that the rare losses are large, and the journal sizes the structure smaller to account for the wider distribution.

2. The diagonal spread is sized to 1% of NLV rather than 2%. The diagonal's greeks are more complex than a vertical or a calendar, and the journal sizes the structure smaller to account for the increased sensitivity.

3. The risk reversal is sized to 1% of NLV rather than 2%. The risk reversal's asymmetric payoff is more complex than a vertical, and the journal sizes the structure smaller to account for the asymmetry.

The exceptions are documented in the playbook's articles on each structure. The journal's rule is that any structure with a more complex risk profile than a vertical spread is sized to 1% of NLV rather than the usual 2%.

Portfolio-level risk

Portfolio-level risk is the total max-loss of all open positions, expressed as a percentage of NLV. The journal's rule is that the total portfolio max-loss should not exceed 12% of NLV at any time. The 12% rule is the cap on the journal's total exposure to all open positions.

The 12% rule breaks down as follows:

• 6% per underlying. The total risk in any single underlying (or highly correlated basket) should not exceed 6% of NLV. The rule allows the journal to have three positions at the 2% sizing in the same underlying, or two positions at 2% and one position at 2% on a correlated name.
• 8% per broad-market factor. The total long delta exposure across all index and equity positions should not exceed 8% of NLV. The 8% rule limits the journal's exposure to the broad-market factor.
• 3% per single-name position. Single-name positions are capped at 3% of NLV per position, with a 6% total cap across all single-name positions. The 3% rule is more conservative than the 2% rule because single-name positions have higher idiosyncratic risk.

The 12% rule is the cap on the journal's total exposure. The journal's typical portfolio is at 8-10% of NLV total exposure, leaving headroom for new positions that meet the playbook's rules.

Drawdown limits

Drawdown limits are the rules that kick in when the journal's NLV has declined by a significant amount. The journal's drawdown limits are:

1. 5% drawdown: stop opening new positions. When the journal's NLV has declined by 5% from the high-water mark, the journal stops opening new positions. The journal continues to manage the existing positions, but no new positions are opened until the NLV recovers to the high-water mark.

2. 10% drawdown: close all positions and pause trading. When the journal's NLV has declined by 10% from the high-water mark, the journal closes all open positions (regardless of the position's individual thesis) and pauses trading for at least 30 days. The pause is the journal's way of stepping back from the market when the methodology is not working.

3. 15% drawdown: full methodology review. When the journal's NLV has declined by 15% from the high-water mark, the journal conducts a full methodology review. The review includes the realized edge sources, the realized hit rate, the realized P&L, and the structural assumptions of the playbook. The journal does not resume trading until the review is complete and the playbook is revised.

The drawdown limits are the journal's last line of defense. The position-level risk and portfolio-level risk rules are designed to prevent the drawdown from reaching the limits, but the limits are the backstop if the rules fail.

The difference between acceptable and unacceptable loss

The journal distinguishes between acceptable and unacceptable loss. Acceptable loss is a position that closed at the max-loss or close to it; the loss was sized for, and the journal is prepared to take the loss. Unacceptable loss is a position that closed at a larger loss than expected, or a position that closed at a loss that was not sized for.

The journal's rule for unacceptable loss is: every unacceptable loss is reviewed in detail, and the review is documented in the lessons-learned article. The review identifies the cause of the loss (mechanical error, rule failure, market move outside the structure's expected range) and proposes a rule revision to prevent the same loss from happening again.

The journal's most common causes of unacceptable loss are:

1. Position sizing errors. A position that was sized larger than the 2% rule, often because the structure's max-loss was miscalculated or the NLV was overestimated. The journal's rule for sizing errors is to document the position separately from the trade log and to revise the position-sizing rule.

2. Adjustment errors. A position that was adjusted at the wrong time or in the wrong direction, often because the adjustment rule was misapplied. The journal's rule for adjustment errors is to document the adjustment separately from the trade log and to revise the adjustment rule.

3. Market moves outside the expected range. A position that was closed at a loss because the underlying moved more than the structure's expected range. The journal's rule for range-exceeded losses is to document the move separately from the trade log and to revise the expected-range assumption.

The journal's rule for unacceptable loss is that the loss is documented in detail, the cause is identified, and the rule revision is proposed. The journal does not tolerate unacceptable loss as a cost of doing business; the journal treats unacceptable loss as a process failure that needs to be corrected.

The risk of taking no risk

The journal's risk management framework is not a prescription for taking no risk. The journal's edges are exploited through the playbook's structures, and the structures require risk to be profitable. The risk management framework is designed to limit the risk to a level that the journal can absorb, not to eliminate the risk.

The journal's rule for the risk of taking no risk is: if the journal's total exposure is below 4% of NLV for more than 30 days, the journal is not taking enough risk. The 4% rule is the floor on the journal's total exposure; the journal's typical exposure is 8-10% of NLV.

The 4% rule is the journal's way of saying that the risk management framework is not a hedge against losses; it is a mechanism for taking the right amount of risk. The journal's view is that the risk of taking no risk (the opportunity cost of not being in the market) is just as real as the risk of taking too much risk (the realized loss of a position that goes against the journal).