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How do you define risk?

  • #1
  • First Post: Jul 14, 2005 6:34pm Jul 14, 2005 6:34pm
I'm currently reading "Smarter Trading" by Haufman. He defines risk as volatility, measured by standard deviation. Volatility = Risk seems to be the common approach from everything I've read on trading. For example - max drawdown is often equated with risk, and that's nothing more than a measure of volatility.

But here is what I can't get out of my mind - shouldn't we be much more concerned with the likelihood that a system will recover than we are with how volitile the equity curve is? I would much rather trade a volatile system with an 95% chance of recovering from any drawdown than a smooth system with a 70% chance of recovering from any drawdown (other factors being equal).

Are there any useful metrics out there that measure a systems ability to recover from drawdown (without caring how volatile the thing is?)

Are there any other basic approaches to defining risk?

Thanks in advance.

James
  • #2
  • Edited Jul 16, 2005 5:34pm Jul 14, 2005 6:56pm | Edited Jul 16, 2005 5:34pm
Alexander Elder defined risk -he named it "a businessman's risk- in his 1992 classic "Trading for a Living" as :

(the maximum amount of money you will risk on any single trade, there's no standard dollar amount... An acceptable buinessman's risk depends, first of all, on the size of your trading account. It also depends on your trading method and pain tolerance.)

I like this statement he wrote: (If you lose even a dollar more than your businessman's risk, including commisions and slippage, you are a loser.)

I hope I could clarify it someway...
  • #3
  • Jul 14, 2005 9:02pm Jul 14, 2005 9:02pm
You know those concrete barricades along the side of the highway? Imagine them bristling with foot long, razor sharp, steel spikes. Sideswipe that with any speed at all and you'll shred your tires and peel the metal from your car.

Imagine first that you have two of those walls of steel; one on either side of the lane you're driving in. The walls are twenty feet away from your car on either side and you are only driving ten miles per hour. What is your risk? What is your chance of crashing and burning?

Now imagine those same walls twenty inches away from your car on either side, but this time you have to drive at 80 miles per hour. What is your risk now? What is your chance of crashing and burning?

The distance between the walls is the distance between your entry and your stop. The speed of the car is your position size. Using a fixed percentage stop (1%, 2%, whatever), the closer you bring the walls together, the faster you "get" to drive, and the faster you'll reach your destination (profit)....and the more likely you'll die. Drive the wide highway at a slower speed. You'll take longer getting to your destination, but you'll at least get there in one piece.

Risk management takes priority over making money. Focus on minimizing your risk and the outcome (money) will take care of itself.

(Gives a whole new meaning to the phrase "Balls to the Wall", doesn't it?
sxaxlxvxaxtxixoxnxbxyxgxrxaxcxexdxoxtxoxrxgx
  • #4
  • Jul 14, 2005 11:46pm Jul 14, 2005 11:46pm
Quoting diallist
You know those concrete barricades along the side of the highway? Imagine them bristling with foot long, razor sharp, steel spikes. Sideswipe that with any speed at all and you'll shred your tires and peel the metal from your car.

Imagine first that you have two of those walls of steel; one on either side of the lane you're driving in. The walls are twenty feet away from your car on either side and you are only driving ten miles per hour. What is your risk? What is your chance of crashing and burning?

Now imagine those same walls twenty inches away from your car on either side, but this time you have to drive at 80 miles per hour. What is your risk now? What is your chance of crashing and burning?

The distance between the walls is the distance between your entry and your stop. The speed of the car is your position size. Using a fixed percentage stop (1%, 2%, whatever), the closer you bring the walls together, the faster you "get" to drive, and the faster you'll reach your destination (profit)....and the more likely you'll die. Drive the wide highway at a slower speed. You'll take longer getting to your destination, but you'll at least get there in one piece.

Risk management takes priority over making money. Focus on minimizing your risk and the outcome (money) will take care of itself.

(Gives a whole new meaning to the phrase "Balls to the Wall", doesn't it?
Great analogy. Great story. Keep it up.

FT
  • #5
  • Jul 15, 2005 12:08am Jul 15, 2005 12:08am
Quoting Redleg
....

But here is what I can't get out of my mind - shouldn't we be much more concerned with the likelihood that a system will recover than we are with how volitile the equity curve is? I would much rather trade a volatile system with an 95% chance of recovering from any drawdown than a smooth system with a 70% chance of recovering from any drawdown (other factors being equal).

Are there any useful metrics out there that measure a systems ability to recover from drawdown (without caring how volatile the thing is?)

Are there any other basic approaches to defining risk?

Thanks in advance.

James
Hi James

Might be totally wrong but isn't time an important factor as well?

Here is a quote from The 21 irrefutable truths of trading - John Hayden
"Risk can be defined as the probability that a trade or a series of trades will result in a loss of equity".

Johan
  • #6
  • Jul 15, 2005 12:38am Jul 15, 2005 12:38am
Quoting diallist
You know those concrete barricades along the side of the highway? Imagine them bristling with foot long, razor sharp, steel spikes. Sideswipe that with any speed at all and you'll shred your tires and peel the metal from your car.

Imagine first that you have two of those walls of steel; one on either side of the lane you're driving in. The walls are twenty feet away from your car on either side and you are only driving ten miles per hour. What is your risk? What is your chance of crashing and burning?

Now imagine those same walls twenty inches away from your car on either side, but this time you have to drive at 80 miles per hour. What is your risk now? What is your chance of crashing and burning?

The distance between the walls is the distance between your entry and your stop. The speed of the car is your position size. Using a fixed percentage stop (1%, 2%, whatever), the closer you bring the walls together, the faster you "get" to drive, and the faster you'll reach your destination (profit)....and the more likely you'll die. Drive the wide highway at a slower speed. You'll take longer getting to your destination, but you'll at least get there in one piece.

Risk management takes priority over making money. Focus on minimizing your risk and the outcome (money) will take care of itself.

(Gives a whole new meaning to the phrase "Balls to the Wall", doesn't it?
very good,thks
  • #7
  • Jul 15, 2005 5:13am Jul 15, 2005 5:13am
Quoting meedo29
Alexander Elder defined risk -he named it "a businessman's risk- in his 1992 classic "Trading for a Living" as :

(the maximum amount of money you will risk on any single trade, there's no standard dollar account... An acceptable buinessman's risk depends, first of all, on the size of your trading account. It also depends on your trading method and pain tolerance.)

I like this statement he wrote: (If you lose even a dollar more than your businessman's risk, including commisions and slippage, you are a loser.)

I hope I could clarify it someway...
Hi meedo29.

Elders talks about
- Size of trading account. Agree this is a big factor in position sizing (and that position sizing is one fundamental determinate of risk.) I use % risk money management, which factors this in.
- Trading method. This is the portion that I have lots of questions about. How do you assess the risk of one trading method compared to another? What factors about a trading method impact risk? Here the traditional method is to equate volatility with risk - and I just have trouble buying that (pun intended ).
- Pain tolerance. Relevant, and fairly simple to assess in my opinion.

Thanks for your input!

James
  • #8
  • Jul 15, 2005 5:26am Jul 15, 2005 5:26am
Quoting diallist
You know those concrete barricades along the side of the highway? Imagine them bristling with foot long, razor sharp, steel spikes. Sideswipe that with any speed at all and you'll shred your tires and peel the metal from your car.

Imagine first that you have two of those walls of steel; one on either side of the lane you're driving in. The walls are twenty feet away from your car on either side and you are only driving ten miles per hour. What is your risk? What is your chance of crashing and burning?

Now imagine those same walls twenty inches away from your car on either side, but this time you have to drive at 80 miles per hour. What is your risk now? What is your chance of crashing and burning?

The distance between the walls is the distance between your entry and your stop. The speed of the car is your position size. Using a fixed percentage stop (1%, 2%, whatever), the closer you bring the walls together, the faster you "get" to drive, and the faster you'll reach your destination (profit)....and the more likely you'll die. Drive the wide highway at a slower speed. You'll take longer getting to your destination, but you'll at least get there in one piece.

Risk management takes priority over making money. Focus on minimizing your risk and the outcome (money) will take care of itself.

(Gives a whole new meaning to the phrase "Balls to the Wall", doesn't it?
Hi Dailist!

Very descriptive - you should become an author!

Your analogy addresses the important of position size and stop loss size. I agree that the larger your position size (relative to your account size) the larger your risk.

I don't necessarily agree with smaller stop loss = smaller risk, though. One of the interesting things I've found in Kaufman's book was in his chapter on stop losses - he argues that smaller stop losses may actually increase risk! On a single trade, a smaller stop loss does make it more likely you will lose on that trade. But in a series of trades, if you put your stops too close you will increase your probability of losing money in the long run. Conversely, making your stops wider only reduces risk to a point - then I think it would increase risk. If wider stops = less risk were always true, then the least risky of all would be trading with no stops - and that is obviously not the case.

Your analogy also doesn't account for other (very important) factors in trading risk - such as trading method. (I realize you probably were not trying to be exhaustive in your analogy. )

Thanks again for your ideas!

James
  • #9
  • Jul 15, 2005 5:28am Jul 15, 2005 5:28am
Quoting marejp
Hi James

Might be totally wrong but isn't time an important factor as well?

Here is a quote from The 21 irrefutable truths of trading - John Hayden
"Risk can be defined as the probability that a trade or a series of trades will result in a loss of equity".

Johan
Hi Johan,

Time - very good point. It doesn't really matter how likely a system (or a single trade) is to recover if it's going to take 500 years for that recover to occur!

James
  • #10
  • Jul 15, 2005 5:48am Jul 15, 2005 5:48am
Hey Redleg,

Most people define risk as the max amount which you accept to lose on a single trade. I see this definition good but a little bit incomplete.

In my opinion, 4 factors must be taken into consideration while defining risk:

1- Pair Volatility
2- Time
3- Account Value
4- Position Size

Account Size & Position Size are related to each other in a way or another. Have you ever heard of the options pricing model? It's simply a formula in which you insert variables and get out a fair value for the call or put options. The same is here but with some differences.

Time is an important factor in options because their value decay with time. In forex, time is of important value as well due to 2 factors:

1- Money engaged in a trade is considered idle money that can't be used until the trade is closed, so it's something like loss of emerging opportunities

2- Rollover is being charged

In my opinion, Risk can be defined as:"The opposite of creating a winning trade with the least possible position size using the least possible account equity in the least possible time."

Think about it and you will see that this opposite is real RISK.

Thanks.

Nader.
  • #11
  • Jul 15, 2005 8:22am Jul 15, 2005 8:22am
I agree with Diallist, and feel everyone should take his analogy to heart. I've tried very elequent and mathmatically elaborate systems to define and determine risk. I even bought a 400+ page risk management course that I belive I read an entire 23 pages prior to common sense kicking in.

I am not a professional trader that manages millions in equity for a financial firm, nor do I manage multiple accounts for currency investors that rely on me to make profitting decisions for them and their money. If you were, you would not be setting your risk theories by advice found in a forum!

I am a simple trader managing my own account, and a modest one at that. I don't need incredible calculations or theories to determine my risk architechture. I just need to use common sense. I trade for profit and pleasure. I enjoy it.

I have determined already what I am willing to risk on any one trade and set that in my platform as a defualt % so it automatically determines this for me when I open.

This is a simple and sound practice as long as I don't open multiple positions on the same pair.

Often, it's easy to miss the forest for the trees.
Capital Preservation is key to long term wealth accumulation
  • #12
  • Jul 15, 2005 9:45am Jul 15, 2005 9:45am
Quoting narafa
Hey Redleg,

Most people define risk as the max amount which you accept to lose on a single trade. I see this definition good but a little bit incomplete.

In my opinion, 4 factors must be taken into consideration while defining risk:

1- Pair Volatility
2- Time
3- Account Value
4- Position Size

Account Size & Position Size are related to each other in a way or another. Have you ever heard of the options pricing model? It's simply a formula in which you insert variables and get out a fair value for the call or put options. The same is here but with some differences.

Time is an important factor in options because their value decay with time. In forex, time is of important value as well due to 2 factors:

1- Money engaged in a trade is considered idle money that can't be used until the trade is closed, so it's something like loss of emerging opportunities

2- Rollover is being charged

In my opinion, Risk can be defined as:"The opposite of creating a winning trade with the least possible position size using the least possible account equity in the least possible time."

Think about it and you will see that this opposite is real RISK.

Thanks.

Nader.
Nader,

Thanks! In what way do you see pair volatility as a factor in defining risk?

James
  • #13
  • Jul 15, 2005 9:48am Jul 15, 2005 9:48am
Quoting MuddBuddha
I agree with Diallist, and feel everyone should take his analogy to heart. I've tried very elequent and mathmatically elaborate systems to define and determine risk. I even bought a 400+ page risk management course that I belive I read an entire 23 pages prior to common sense kicking in.

I am not a professional trader that manages millions in equity for a financial firm, nor do I manage multiple accounts for currency investors that rely on me to make profitting decisions for them and their money. If you were, you would not be setting your risk theories by advice found in a forum!

I am a simple trader managing my own account, and a modest one at that. I don't need incredible calculations or theories to determine my risk architechture. I just need to use common sense. I trade for profit and pleasure. I enjoy it.

I have determined already what I am willing to risk on any one trade and set that in my platform as a defualt % so it automatically determines this for me when I open.

This is a simple and sound practice as long as I don't open multiple positions on the same pair.

Often, it's easy to miss the forest for the trees.
Hi Mudbudda,

% risk money management makes a lot of sense, but it doesn't help me to understand whether system A is more or less risky than system B. I think that question is worth trying to figure out - simply or otherwise.

James
  • #14
  • Jul 16, 2005 7:23am Jul 16, 2005 7:23am
Quoting Redleg
Nader,

Thanks! In what way do you see pair volatility as a factor in defining risk?

James
I see pair volatility in linear realtionship with risk of course, which means that as volatility increase, the risk increases as well.

Let me re-phrase the statement a little bit, Risk is "The opposite of creating a winning trade on the lowest volatile currency pair with the least possible position size using the least possible account equity in the least possible time."

Sorry, I just missed this in the previous post

Thanks,

Nader.
  • #15
  • Jul 16, 2005 11:10am Jul 16, 2005 11:10am
Quoting narafa
I see pair volatility in linear realtionship with risk of course, which means that as volatility increase, the risk increases as well.

Let me re-phrase the statement a little bit, Risk is "The opposite of creating a winning trade on the lowest volatile currency pair with the least possible position size using the least possible account equity in the least possible time."

Sorry, I just missed this in the previous post

Thanks,

Nader.
Nader,

But why does increased volatility imply increased risk. Everyone says it does, but I'm having trouble coming up with a good reason to explain such a relationship.

Thanks.

James
  • #16
  • Jul 16, 2005 4:14pm Jul 16, 2005 4:14pm
Quoting Redleg
Nader,

But why does increased volatility imply increased risk. Everyone says it does, but I'm having trouble coming up with a good reason to explain such a relationship.


James
The key word is "imply". Volitility itself does not imply risk any more than when I stand on the shore and watch 10 meter waves come in or when I stand on the shore and watch 1 meter waves come in. Either way I don't experience increased risk unless I get too close to the action.

However when we define what our relationship is with the volitility then we can create situations where risk increases and decreases relative to our trading parameters.

If I take a 2 meter punt out in 2 meter waves I run a significant risk of capsizing due to the relationship of the boats capabilities relative to wave size. If I get in an ocean liner 2 meter waves represent little more risk in most situations than .3 meter waves.

With Forex trading and working with MM's who guarantee stops in all but the most extreme conditions there is no greater risk to your account than what you defined when you placed your stop -- regardless of the volatility -- but when volatility exceeds a certain point the MM will no longer protect your stops and slippage becomes a risk factor. Trading other financial instruments such as futures and equities usually includes increased slippage with increased volatility and therefore increased risk because you cannot be sure of your exit. Trading with mental stops implies increased risk with increased volatility for obvious reasons. What makes this a bit blind is that where volatility and liquidity increase (with hard stops) in proportion -- risk remains the same. So risk is somewhat dependent on liquidity as well. Therefore there are times when increased volatility does not imply increased risk if liquidity remains in proportion to the volatility.

Of course I've been talking about risk concerning exit stops but some appear to be looking only at the risk of a stop being hit with increased volatility. Increased volatility implies an increased probability of a stop being hit but it also implies an increased probability of a target being hit. Therefore your risk and reward both increase with an increase in volatility so the question about whether risk increases would be more complex and not related so much to volatilty itself. All things being equal risk does not increase in that situation if volatility and liquidity remain in proportion and do not threaten your chances of exiting according to your risk parameters. Risk does not increase with volatilty if you can be sure your exit is going to happen where you define it.

Another point is that if you are not trading a system but trading discretionarily and kind of making it up as you go along then using the same size stops in an increasingly volatile market then you risk a greater number of losses. However if your targets are getting larger while maintaining the same stop size then perhaps your risk may not increase because, although your stop size is causing you more losses your targets are getting you larger wins. Therefore implied risk may remain the same with greater volatility in that kind of situation as well.

There are so many ways to look at risk but the real answer is that risk is always relative to other objectives and does not exist on its own. Increased volatility implies no risk to someone who is not in the market.

FT
  • #17
  • Jul 16, 2005 4:28pm Jul 16, 2005 4:28pm
Quoting Redleg
How do you assess the risk of one trading method compared to another? What factors about a trading method impact risk?
Probably the greatest risk and hardest to quantify when comparing one trading system over another is the traders propensity to interfere with the system. A system that is not well suited to a trader will represent the greatest account risk whereas a system that is well suited to the traders psychology will represent the least risk.... assuming the systems are both winning systems.

FT
  • #18
  • Jul 16, 2005 6:22pm Jul 16, 2005 6:22pm
Quoting Redleg
- Trading method. This is the portion that I have lots of questions about. How do you assess the risk of one trading method compared to another? What factors about a trading method impact risk? Here the traditional method is to equate volatility with risk - and I just have trouble buying that (pun intended ).
from my humble point of view, I think that the trading method has a wider meaning other than comparing trading systems...

For example, a trader who trades the news suffers much higher risk than another trader who only trades quiet markets, even if they use the same trading system...


I think it's very obvious that risk is equated with volatility, even though profit also is equated with volatility...

It happened to me many times to set a relatively tight stop during wild markets, the prices touch my stop to close the trade and then sprints in my inteded direction, by then I'm being left outside, feeling sad and angry...
  • #19
  • Jul 17, 2005 3:44am Jul 17, 2005 3:44am
Quoting meedo29
It happened to me many times to set a relatively tight stop during wild markets, the prices touch my stop to close the trade and then sprints in my inteded direction, by then I'm being left outside, feeling sad and angry...
That's why I agree with FT in his point of view. As implied volatility increases, both risk and reward are increased provided that liquidity is still in proportion and in synchronism. When trading a highly volatile market, you should consider widening the stop/limit targets instead of tightening them.
  • #20
  • Jul 17, 2005 4:14am Jul 17, 2005 4:14am
Quoting Redleg
Nader,

But why does increased volatility imply increased risk. Everyone says it does, but I'm having trouble coming up with a good reason to explain such a relationship.

Thanks.

James
In the options/futures markets, which I consider the hardest ones to trade, when volatility increases, you would expect gaps, runaways, and all the wild price actions that you can expect. Unlike the forex market, where gaps are limited to week openings, stops in the options/futures markets are not gauranteed, and with volatility increasing, you might expect to lose or win more than your loss/profit target by several points. This is not considered slippage, but is considered more risk and more reward over an open trade.

Increased volatility means nothing to someone on the sidelines who is not willing to enter the market, but means a lot to someone who is watching to enter. It must affect the price you will enter at, it affects the whole view about the trade itself, it affects the stop/limit targets, everything is affected only if you are looking to enter the market.

As FT said, liquidity plays an extremely important role. Usually, volatility increases due to the increase in liquidity, but not in all times.

Another thing to note is that there are 2 types of volatility:

1- Historical Volatility
2- Implied Volatility

Historical Volatility reflects the past price movements of the underlying asset, while Implied Volatility is a measure of market expectations regarding the asset's future volatility.

Implied volatility is much more important than the historical one, because it aims at antcipating the future volatility. The implied volatility is mainly calculated based on the behavior of the options prices.

Another good measure used in stocks is the beta, which is a risk factor comupted by measuring how volatile a particular stock is relative to the general market.

A beta of 1, means that the stock is of the same volatility as the general market.

A beta of 0.5, means that the stock is half the volatility of the general market.

And a beta of 3, means that the stock is 3 times the volatility of the general market.

The beta is usually considered a risk measure as it increases, the risk increases, but that's only for the historic data.

Since the forex market has no general market, the beta can't be calculated using the same way. I have been searching for a method to calculate a beta for a certain pair, but all my attempts failed till now.
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