How to control risks when the market plummets?

Author: goodalexander

Compiled by: Deep Tide TechFlow

Lesson 1: Understand the maximum drawdown of your total portfolio

The first step in managing risk is to fully understand the maximum drawdown your portfolio may face. Specifically, it is recommended to sort out all your investment exposures, convert them into a total return sequence, and analyze the retracement situation in the following dimensions:

• A. Peak to Through Drawdown.
• B. The retracement in a single transaction, especially overnight retracement (Session Level Drawdown, overnight retracement in stock investment is particularly important because you cannot sell at night).
• C. Daily Drawdown.
• D. Monthly Drawdown.

Do not consider any specific market factors when performing these analyses and remain neutral.

It is recommended to analyze the retracement data for the past 1 and past 10 years respectively. However, there may be some tools in your portfolio that lack 10 years of historical price data. This can be solved by establishing a profit matrix and selecting a proxy tool. For example, for a tool with a shorter history like Hyperliquid, XRP can be selected as a proxy tool, as its historical data can be traced back to 2015.

An important question in investment or trading is: Is there a possibility that losses exceed the expected range? You need to assume that the actual fluctuations in the market may exceed your simulated value, because the market tends to break through the limits of historical data.

Maximum retracement = Max (3x maximum loss in the past 1 year, 1.5x maximum loss in the past 10 years).

There is also an important reminder: when calculating these retracements, you need to eliminate your strategic advantages and calculate only the losses of the tool itself, rather than the losses based on the retracement.

The key indicator for measuring the effectiveness of risk management is: monthly profit as a percentage of the maximum drawdown. By contrast, the Sharpe Ratio is not suitable for measuring actual risks because it does not reflect real scenarios (such as whether you will collapse and switch to accounting due to huge losses).

Lesson 2: Understand your key markets Beta exposure

In risk management, it is crucial to understand the relevance of your portfolio to the market (i.e., Beta exposure). Here are some typical market beta exposure categories:

Traditional Financial Markets (TradFi):

• S&P 500 Index (S&P 500, code: SPY)
• Russell 2000 Index (Russell 2000, code: IWM)
• Nasdaq Index (Nasdaq, code: QQQ)
• Crude Oil (Oil, code: USO)
• Gold (Gold, code: GLD)
• China Market Index (Code: FXI)
• European Market Index (code: VGK)
• Dollar Index (Dollar Index, code: DXY)
• Treasuries (code: IEF)
• Crypto Market (Crypto):
• Ethereum (ETH)
• Bitcoin (BTC)
• Top 50 altcoins (excluding ETH and BTC)

Most investment strategies do not have an explicit market timing strategy for beta exposure in these markets. Therefore, these risks should be minimized to zero. Generally, the most effective way is to use futures tools because they have lower financing costs and require less balance sheets.

Simple rules: Get a clear understanding of all your risks. If there is uncertain risk, try to avoid it through hedging.

Lesson 3: Understand your key factors exposure

In investment, factor exposure refers to the extent to which your portfolio is affected by certain market-specific factors. Here are some common factor exposures:

• Momentum factor: Pay attention to price trends, buy rising assets, and sell falling assets.
• Value: Invest in undervalued assets, such as stocks with low price-to-earnings ratios.
• Growth: Invest in assets with fast growth in revenue or profits.
• Carry: Invest in high-yield assets through low-cost financing.

These factors are difficult to capture in actual operation. For example, you can capture the momentum factor of the S&P 500 through ETFs (such as MTUM), but in fact it means your strategy may tend to "chase ups and sell downs." This is especially complicated because in a trend strategy, you may intentionally assume certain factor risks.

Some effective indicators for measuring factor exposure include:

• Average price Z score for the non-trend strategy section (the relative position of the price).
• The average price-to-earnings ratio (or equivalent indicator) for the non-value strategy part.
• The average income growth rate (or expense growth rate) for the non-growth strategy segment.
• The average rate of return for the portfolio (if your rate of return is in the medium double-digit range, it may mean you are taking higher risk of the perpetrator factor).

In cryptocurrency markets, trend factors tend to fail with the overall market fluctuation, as too many investors use similar strategies, resulting in the potential risks being amplified. In the foreign exchange market, there are similar problems with earning strategies (such as arbitrage transactions). The higher the return, the greater the potential risk.

Lesson 4: Adjust position size based on implicit volatility, or set clear

position size parameters for different market environments

In risk management, using implied volatility rather than realized volatility to adjust position size can better cope with market uncertainty. For example, when financial reports are released or elections are approaching, implicit volatility often reflects market expectations more accurately.

A simple adjustment formula is: (Implicit volatility/Real volatility in the past 12 months) × Maximum retracement in the past 3 years = Assumed maximum retracement in each instrument

According to this formula, set a clear maximum retracement limit for each tool. If a tool lacks implicit volatility data, it may mean that it is insufficient liquidity, which requires special attention.

Lesson 5: Beware of the cost shocks caused by insufficient liquidity

(liquidity risk)

In poor liquidity markets, transaction costs may increase significantly. A basic principle is: Never assume that you can sell more than 1% of your daily trading volume in one day without having a significant impact on the price.

If the market becomes non-liquid, it may take several days to completely clear the position. For example, if you hold positions that account for 10% of the day's trading volume, it may take 10 days to complete the liquidation. To avoid this, it is recommended to avoid holding positions exceeding 1% of the daily trading volume. If this ratio has to be exceeded, it is recommended to assume that every 1% increase in the maximum drawdown of the tool will double (although it seems conservative, this assumption is very important in practice).

Lesson 6: Identify the "only risk that may cause me to collapse" and

conduct qualitative risk management

Although the above methods are mainly quantitative analysis, risk management also requires qualitative forward-looking judgment. At any time, our portfolio may face hidden factor exposure. For example, investors who now hold long positions in USDCAD may face risks associated with Trump’s tariffs. Such risks are often not captured by historical volatility because news events change too quickly.

A good risk management habit is to ask yourself regularly, "What is the only thing that can break me?"

If you find that the positions you hold are not related to certain potential risks, such as the association of USDCAD positions with Trump tariffs, consider hedging these risks through relative value trading, such as investing in Mexican stocks rather than U.S. stocks.

In fact, most historically significant losses are not particularly surprising in the multi-week time frame. For example, during the Taper Tantrum period, the market has long realized that interest rate-sensitive assets may have problems. Likewise, many signs have emerged before the COVID risk breaks out. By identifying these risks in advance, you can better protect your portfolio.

Lesson 7: Clarify your risk limit in advance in the risk framework

Before making any investment or bets, it is important to clarify the following key issues in advance:

• What is the specific content of the bet? You need to be clear about the core logic and goals of this deal.
• How much loss are you willing to bear? Set an acceptable range of losses in advance to avoid emotional decisions.
• How to reduce market exposure? If the market trend is not good, do you have enough strategies to control the risk?
• Can you exit the transaction in time? If the trading is not good for you, can you close your position quickly? Is it necessary to reduce the position in advance?
• What is the worst case? Identify and be prepared to respond to the risk factors that may lead to significant losses.

Record the answers to these questions, or keep track of them in some way, which can help you manage risks more clearly.

Lesson 8: Reflection on your own risk management performance

In risk management, it is crucial to maintain a clear awareness of one's own performance. If your reaction to this is "Haha, I won't do this" or "What does this have to do with my ordering Wendy's burger", then it's very likely that you need to cut 1/3 of the risk right away, or you shouldn't take these risks from the beginning.

Remember, Wendy's menu is cheap and simple - if you treat the market as Wendy's, then your position should also be kept at a low risk, rather than "betting" as luxuriously as you go to a Ritz hotel.

Of course, I also know that most people won’t do exactly as they suggest. I totally understand that posting this can be futile, so you don't need to remind me of this again.