Question About Risk and Margin

[tommog]

Hi,

Have any of you ever worked for a hedge fund or been invloved in the management of funds? Id like to know more about how margin comes into your risk plan.

Imagine the scenario where you have a fund of £2 million to manage and you want to risk 1% of that on a position i.e £20,000. However the margin requirement for this position is £100,000. So thats effectively £120,000 of your pot tied up in the position which is more than the 1% you planned to risk on that trade.

So do you treat the margin requirement for your position as part of the risk? Or do you work out the margin requirement for your position and then calculate what the percentage risk is from the remaining account balance (after margin requirements have been deducted?)

Hope this makes sense,

Thanks

 

[TheBramble]

Your risk is your cash. Your margin is your buying power.

You have $2M cash. You have 4:1 margin which means you have $8M buying power.

You're taking a position with a risk of $0.25 per share. The shares are trading at $50.

You only want to risk 1% of your cash trading capital (1% of your 'real' money – the $2M) which is $20K.

So in cash risk terms your position size would be (total risk allocated/risk per share) $20K/$0.50 = 40K shares, if you have sufficient margin (buying power) and no other trade size constraints (see below).

40K shares at $50 per share is $2M. If you're willing to commit 25% of your buying power to this one trade, your set fair to go.

Risk is (or should) always be calculated on cash, not margin.

Most traders will have separate rules for how much of their margin they will commit per trade. 10% is a common figure for independent traders. In this case, using that data, you'd limit your position to just 16K shares. Your max risk drops to 0.4% of your cash capital which would then be $8K.

It’s normal, if you’re working with relatively tight stops, to come up with a trading position requiring all, or more, of your margin. Having a constraint on total trading size stops you bring ‘all in’ the market.

You only have to consider a similar trade setup described above on GOOG currently at just over $500/share. Same max risk and risk per share without any total trading size constraints and you’d need buying power of $20M.

Hedgies generally use somewhat more complex trade structuring based on their profile, investment style, current investment area of interest and of course, any committed investment aims for their clients. It will also be largely governed by their performance to date and where they are in their trading year. But it’s all going to be based around the risk and margin described above.

 

[tommog]

ok thanks for the reply