Source Link: https://algotrading101.com/learn/how-to-measure-trading-risks/
If you are into the trading business, another important aspect that you need to look into or learn is trading risks.
This article will discuss trading risks and how to measure them. Read on if you want to know more.
What are trading risks?
Risks refer to the potential, permanent (long-term) losses in your trading business. You need to determine these risks and come up with strategies to prevent these from affecting your business.
Way to Measure Trading Risks
Risk is a subjective and multifaceted topic. However, there are ways to measure risks, which include measurement based on:
- quality of trading decisions
- past performance
- hedging and portfolio diversification
Risk measurement by the quality of trading decisions
A trading risk should be measured based on the quality of the decision. A quality decision is one that gives the highest risk-adjusted expected outcome.
Here is the formula:
Expected Outcome = Probability of Success x Reward – Probability of Success x Loss.
Here are some examples of trading decisions:
A. Good quality decision
You buy Bitcoin Cash at 3X leverage because you know that some puppet-master in the background is going to pump it.
B. Low-quality decision
You buy Bitcoin Cash at 3X leverage because “everyone thinks cryptocurrency is easy money, and you FOMO-ed (fear-of-missing-out).”
The downside of measuring trading risks based on the quality of the trading decision is that it is subjective. You cannot put a specific value on how low or good the decisions are. Also, the trader’s competence is another aspect of great influence.
Risk measurement based on past performance
This is not the most accurate way to measure trading risks, but most people do it as it is convenient, and they have no other way to measure risk in a standardized manner.
This method measures trading risks using drawdowns or volatility of returns.
What is a drawdown?
It refers to the biggest % drop in your portfolio. Thus, you would want a small drawdown compared to your returns. The smaller the drawdown-returns ratio, the more likely you are risking less to make more.
What is the volatility of returns?
The volatility of returns refers to how volatile your performance is, as opposed to how volatile the market is. It can be measured using the standard deviation of your returns.
The low volatility of returns means that you are consistently making good and profitable trading decisions. It also goes hand in hand with low drawdowns.
Some of the problems with measuring risks using drawdowns and volatility of returns are the following:
- High drawdowns and volatility of returns are not necessarily risky moves.
- Different trading styles lead to different styles of returns and do not mean that one strategy is riskier than the others.
- Sometimes, historical data can create a selection bias.
Risk measurement based on hedging and portfolio diversification
Let’s look into hedging and portfolio diversification.
Hedging
Hedging refers to the strategy that tries to limit the risks in your financial assets.
So, if you believe Stock X has great technology, you want to make a long bet on its tech.
But aside from the tech, you also need to bet on other factors, including its operations, marketing, management, market influence, and more.
This is when hedging comes in. You need to hedge away the unwanted factors.
We find a stock similar to Stock X in every way except its tech. Let’s call this Stock Y.
We need to long Stock X and short Stock Y following this formula:
Stock X – Stock Y = (A+B+C) – (A+B-D) = C – D
Where A, B, C, and D are factors, and C and D represent the tech of Stocks X and Y, respectively.
With hedging, you can improve the risk-adjusted expected outcome.
Portfolio Diversification
With portfolio diversification, you produce the highest volatility-adjusted expected outcome. You create a portfolio of assets to get a mix with:
- historically high returns
- low volatility
- low correlation between assets
Also, traders create a portfolio of strategies to get the same outcome.
Measuring trading risks with hedging and portfolio diversification have two possible drawbacks.
- High volatility assets are not necessarily risky if the trader understands them and knows how to manage them.
- All figures are historical, which can create some bias.
Frequently Asked Questions
What is the biggest risk in trading?
The biggest risk in trading is not what you don’t know; it is believing firmly in something that isn’t true.
What are the different forms of risks?
Different forms of risks (which sometimes are overlapping) include the following:
- risk of losing money, falling short and missing opportunities
- FOMO risk
- credit risk
- illiquidity risk
- leverage risk
- funding risk
- over-diversification risk
- risk associated with volatility
- black swan risk
- career risk
- valuation risk
- correlation risk
- interest rate risk
- purchasing power risk
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