How to control risks when the market plummets?

Compiled: Deep Tide TechFlow

Lesson 1: Evaluate the maximum portfolio drawdown

Effective risk management begins with a comprehensive understanding of the maximum loss a portfolio may bear - the maximum drawdown. This requires integrating all investments, generating a total return sequence, and analyzing the following retracements:

• A. Maximum retracement from peak to valley: Maximum decline from highest point to lowest point.
• B. Single trading drawdown: Pay special attention to overnight drawdown, especially for stock investment.
• C. Daily drawdown: Daily investment loss.
• D. Monthly drawdown: Monthly investment loss.

Analysis should be neutral without considering specific market factors. It is recommended to analyze data in the past year and decade respectively, and for tools with insufficient data, similar tools with longer historical data can be used as an alternative (for example, using XRP as an alternative to Hyperliquid).

The key question is: Is the potential loss likely to exceed expectations? It is important to consider that market volatility may be beyond the scope of historical data.

Maximum retracement estimate formula: Max (3 times the maximum loss in the past year, 1.5 times the maximum loss in the past decade). Note: When calculating retracements, the strategic advantages should be excluded and only the losses of the tool itself should be calculated.

The key indicators for measuring the effectiveness of risk management are: monthly profits as a percentage of the maximum drawdown. The Sharpe ratio does not apply because it does not reflect real-world risks, such as investment termination caused by huge losses.

Lesson 2: Identify Key Markets Beta Exposure

It is crucial to understand portfolio and market relevance (Beta exposure). Common market beta exposures include:

Traditional financial markets:

• S&P 500 Index (SPY)
• Russell 2000 Index (IWM)
• Nasdaq Index (QQQ)
• Crude Oil (USO)
• Gold (GLD)
• China Market Index (FXI)
• European Market Index (VGK)
• Dollar Index (DXY)
• U.S. Treasury (IEF)

Cryptocurrency Market:

• Bitcoin (BTC)
• Ethereum (ETH)
• Top 50 altcoins (excluding ETH and BTC)

Most strategies do not operate on market timing for these exposures and should be minimized to zero. Futures tools are usually effective hedging tools.

Core principles: Clarify all risks and hedge uncertain risks.

Lesson 3: Identify key factor exposure

Factor exposure refers to the extent to which the portfolio is affected by specific market factors, such as:

• Momentum factor
• Value Factor
• Growth Factor
• Perk factor

These factors are difficult to capture. Effective indicators include: average price Z score for non-trend strategies, average price-to-earnings ratio for non-value strategies, average income growth rate for non-growth strategies, and average return rate for portfolios (high yields may imply high perk factor risk). In cryptocurrency and forex markets, the risks of trends and arbitration strategies are amplified.

Lesson 4: Adjusting position size based on implicit volatility

Adjusting the position size with implicit volatility rather than the volatility achieved can better cope with market uncertainty. A simple formula is: (Implicit volatility / Actual volatility in the past 12 months) × Maximum retracement in the past 3 years = Assumed maximum retracement for each instrument. Tools that lack implicit volatility data are insufficient in liquidity and require extra caution.

Lesson 5: Beware of liquidity risks

The market with poor liquidity is expensive to trade. Principle: Avoid selling positions that exceed 1% of the daily trading volume in one day. If exceeded, then assume that the risk doubles for every 1% increase in maximum retracement.

Lesson 6: Identify the "Only Risk That Could Make Me Crash"

Risk management requires qualitative analysis. Ask yourself regularly: "What is the only thing that can break me?" and avoid these risks through hedging strategies.

Lesson 7: Preset risk limit

Before any investment, make it clear: bet content, bearable losses, exposure reduction strategies, exit mechanisms, and worst-case scenarios.

Lesson 8: Reflect on risk management performance

Continue to reflect on risk management performance and adjust strategies based on actual conditions. Stay cautious and avoid taking too much risk.

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