Trade Sizing Techniques for Drawdown and Tail Risk Control
27 Pages Posted: 21 May 2012 Last revised: 7 May 2013
Date Written: May 21, 2012
This article introduces three algorithms for trade sizing with the objective of controlling tail risk or maximum drawdown when applied to a trading strategy. The first algorithm relies on historical volatility estimates while the second uses tail risk estimates obtained by applying Extreme Value Theory (EVT) to estimate Conditional Value at Risk (CVaR); the third algorithm also uses Extreme Value Theory applied to the drawdown distribution to compute the Conditional Drawdown at Risk (CDaR). These algorithms are applied to 10 years of daily returns from a trend following strategy trading the EURUSD and NZDMXN currency pairs. In each case, the performance of the algorithms is analysed in detail and compared to the original strategy. The ability of these algorithms in terms of tail risk and drawdown control is evaluated. The techniques presented in the article are readily applicable by investment managers to compute adequate trade size while maintaining a constant level of tail risk or limiting maximum drawdown to a chosen value.
Keywords: Money management, trade sizing, leverage, quantitative strategies, quantitative trading,systematic strategies, Extreme Value Theory EVT, Expected Shortfall ES, Conditional Value at Risk CVaR,VaR,tail risk,risk management,maximum drawdown,Conditional Drawdown at Risk CDaR,GARCH,CTA,managed futures,FX
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