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Alternative Market Briefing

Relying on stop losses may not be the best choice for risk management

Friday, April 27, 2018

The vast majority of fund managers rely on stop losses to manage risk. But is there a better way? Delegates at the recent Opalesque Connecticut Roundtable note that there are some flaws when it comes to relying on stop losses for risk management.

"People talk about stop losses like they're great tools and reliable and how risk should be managed. But from my point of view - that of the options nerd - these stop losses have locked you into a short gamma profile," says Nancy Davis, Managing Partner, at Quadratic Capital. "What I mean by short gamma is that when you have a long position and it goes against you, you stop out by selling your long after it's gone down. So, by definition, you're selling low. Or when you are short something and it's going up, you stop your loss as it's going up. This means you are buying high. Selling low and buying high isn't what we're supposed to be doing as managers, but we accept it because it's better to sell low than to sell even lower. But neither is really great."

Davis argues that by quantifying potential losses fund managers can make more educated positions about how to manage risk. Waiting to pull the trigger on a stop loss at the same time everyone else is can create a variety of pressures on the portfolio and raise questions about liquidity. By quantifying potential losses at the point of putting a position on, these concerns are lessened.

"When we talk about liquidity, to me liquidity risk is......................

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