Hedge Fund Trader Risk/Profit Question

mswoonc's picture
mswoonc - Certified Professional
Rank: King Kong | banana points 1,045

What is the average daily VaR of a trader? Senior, junior, etc...?
If a trader has 20mm capital and let's say he is down -3K and he holds on to the position having the conviction that it will eventually go his way and it went down to 5K and hes keep averaging his position, do they care?

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Comments (17)

Dec 23, 2016

Anyone?

Dec 24, 2016

As always, the answer is "it depends"...

Dec 25, 2016

typically, you start from capital, give expected annual return, expected vol of strategy, to determine baseline for acceptable drawdowns (intraday, daily, montly, yearly)

so, with 20mm of capital, a typical profit target/expectation is 20%, or 4mm/year
4mm/year = avg daily gain of 16k (if you make 16k every day, you'll make 4mm for the year)
This is simple math, no compounding or increasing of risk as your P&L cushion increases.

So, just with this, and in the risk 1 to make 2 theory, an acceptable intraday drawdown of 8k/day makes perfect sense (assuming the strategy has the numbers to fit the risk 1 to make 2 vol profile).

Dec 27, 2016

Thanks for your feedback. I know every funds vary, as far as risk limits given to the trader but is this your assumption or is this how funds typically measure their traders risk?

Dec 27, 2016

there is no "typical" but this is a baseline to use given the numbers you started with. Since every firm is different, there is no "cookie cutter" way to do it...however, this method will get you 80% there with most funds.

These are the numbers/methods that i've seen from real funds and banks.

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Dec 28, 2016

really depends on what you trade as well. Trading equities is much different than say commodities like power. In power spot prices can go from $40/MWh to $999/MWh the next hour and then back down to $38/MWh. VaR is generally much higher in power. That being said Ive know Traders who have had the right consensus but have been stopped out due to short term volatility

it depends

Jan 4, 2017

The Value-at-risk is calculated firm-wide. Portfolio-wise ** ** ** .

For example a midstream estimates the the worst they can lose in the next ten days is 5 millions with a confidence interval of 95%.

In Commodities,
It's a function of volume, volatility and correlation and a confidence level % based on the probabilities of distribution.

Yes they do care, and should not care about your 'expectations' when they have a firewall between Sales Trading and risk management 'geeks'.

In your example,
AVERAGING down would increase, not lowering the VaR.

The last part of the answer to your question is strictly a** function** of where you work.

Category 1:
A utility(NRG), Wholesalers(Direct Energy) Midstreamer or Refiner, typically are Hedgers with limited trading.

They usually give to people nice ** trading title to make them feel important ... but the general rule is that these people can't, won't be able, aren't allowed to take 'considerable' inventory and price risk even if sometime they are absolutely right.
**
Category 2:**
Banks are regulated nowhere other industry. In Commodities have bigger VaR than category one, they take the other side of category 1 'the hedgers' (but it's in function of the enormous balance sheet as a % of equity).

Category 3:

The Trade Houses (Trafigura, GLENCORE), and Hedge-Funds are total different animals and their culture (not bound by the limitations and regulations in Category 1 & 2) allows them taking and giving considerable **** risk-units. They also give you a rope. Typically, will poach someone in the category 1 with well-known strategies and give more room than needed once in the hot spot.

Best Response
Jan 6, 2017

To answer your specific question...

While, as I previously mentioned, the actual numbers will vary a lot, you won't be too far wrong if you assume arnd 1% daily VAR. Assuming it's the 95% garden variety VAR applied to 20MM capital, gives you $121k rough estimate for daily PNL (also assuming my arithmetic is correct). Therefore, 3k shouldn't be viewed as significant by a risk manager.

All that said, the answer is still mostly "it depends"...

    • 2
Jan 6, 2017

I really don't know.

With some exceptions, most hedge fund traders just do what the researchers tell them to do, and generally do yeomans' work at it.

I think the researcher or the PM gets most of the upside at a hedge fund. I think the trader does a good job of helping the PM execute on his/her strategies.

I think that typically $30mm isn't in the cards for traders. I don't think $30mm is in the cards for most people, even in finance.

Jan 6, 2017
IlliniProgrammer:

I really don't know.

With some exceptions, most hedge fund traders just do what the researchers tell them to do, and generally do yeomans' work at it.

I think the researcher or the PM gets most of the upside at a hedge fund. I think the trader does a good job of helping the PM execute on his/her strategies.

I think that typically $30mm isn't in the cards for traders. I don't think $30mm is in the cards for most people, even in finance.

Firstly, this above is a little misguided...

Secondly, in answer to the original question... In theory, yes, every dollar you make should be the same. However, in practice, there are all sorts of effects, including the one that OP is alluding to. It's impossible to generalize, as there's a variety of people doing a whole variety of thing in the mkt.

Jan 6, 2017

Thanks guys.

IlliniProgrammer:

I think that typically $30mm isn't in the cards for traders. I don't think $30mm is in the cards for most people, even in finance.

That was supposed to be the trading revenue for the firm. There should be quite a bit to deduct to arrive at pay.

Martinghoul:

In theory, yes, every dollar you make should be the same. However, in practice, there are all sorts of effects, including the one that OP is alluding to.

Are you just referring to human errs by the trader? Or also to setup of the fund, so that risk aversion is to some extent dictated by management? If the first, how does a trader's boss/manager incentivize traders to stay more risk neutral (anything else than bonus)?

Jan 6, 2017

First of all, I naturally assumed that the OP isn't referring to execution traders, as it's an extremely uninteresting question. Execution traders have no real reason to either be "non-neutral" nor to earn $30 mil for their fund (at least not to my knowledge).

So, presumably, the question applies to someone who, for the avoidance of confusing terminology, is a "risk taker" (a PM, for instance). In this case, effects such as the one that the OP alludes to (i.e. people who have made money tend to get increasingly risk averse towards the end of their accounting year) are a fact of life. In fact, these things are simply manifestations of common behavioral biases, which, believe it or not, HF risk takers aren't immune to. The effect that the OP mentioned in particular sounds like one of the basic illustrations of "prospect theory" in action. It's basic human nature, innit? And yes, some funds' incentive schemes are structured in such a way as to exacerbate these behavioral effects (reason being that individually irrational behavior may produce a better outcome for the fund as a whole). In light of this, it's not obvious to me what a boss/manager should do.

Jan 6, 2017

A buyside execution trader should not and is not expected to be risk neutral. They add value mostly in the less liquid stuff, and if a PM wants to take a significant position in that kind of name, they expect to pay more for the last lot than the first (which makes it inherently riskier)

The psychological loss aversion bias you refer to is probably more applicable to prop traders (who I guess are all at HFs now). If they have a hurdle rate before carry, that helps, as they get more of the last dollar than the first dollar, offsetting the bias somewhat. But as academics and LPs have been lamenting for years, hurdle rates tend to be lower than optimal.

Jan 6, 2017

Seemples: high risk = low beta * high leverage

Take all these theories about HFs with a pinch of salt.

Jan 6, 2017