What is the Best Way to Measure Risk?–Part 3
This article originally appeared in the Ask Jack column on Bidnessetc.com. Each article answered a question submitted by readers.
This is last of three articles in response to this question. In the first article, we considered the appropriateness of using volatility (as measured by the standard deviation)—the most widely used risk metric—to measure risk. In the second article, we considered alternative—and I would argue, better—risk measures. In this final article, we shift our focus from measuring past risk to gauging, as well as controlling, future risk. In the previous two articles, we had discussed risk interchangeably from the perspective of both investors and traders, as risk measurement was equally applicable to both groups. In this article, we will limit our perspective to the trader because only the trader has direct control over future risk.
Track record-based risk measurement can provide some guidelines as to the risk inherent in an investment or a strategy. However, the ability to assess and, by implication, control future risk is more critical. Barring unusual circumstances, such as an unexpected event that triggers an abrupt, large price move, traders can reasonably define as well as control their risk. The following are several important ways this goal can be achieved:
- Define the maximum risk per trade—The trader can define the maximum percent loss to be allowed on any single trade (e.g., 1%). This risk constraint can be achieved by determining the stop-loss point required for the trade and then setting the position size so that the loss will not exceed the intended maximum loss level if the stop point is hit.
- Use options to precisely define risk—Risk can be precisely defined using long options. if a trader uses long options to express a trade idea, instead of outright long and short positions, then the risk can be precisely defined by the premium paid for the options. Of course, this approach would only be applicable in situations where long options appear to provide an equal or better method of expressing a trade than does a direct long or short position.
- Set a maximum cumulative loss point—The trader can establish a rule that all positions would be liquidated if a certain cumulative loss level is hit. For example, the trader could set a rule that the entire portfolio would be liquidated if the portfolio value was down 10% (or any other selected number) from its starting level. Such a loss cutoff could be reset periodically (e.g., at start of each year). The cumulative loss cutoff could also dynamically adjust the reference point. For example, a 10% loss liquidation rule could be set relative to an equity peak that is reset each time a new equity high is reached. This latter approach would limit the maximum retracement of the portfolio from any achieved high to 10%.
All of the above approaches provide very effective means for accurately gauging and controlling future risk.
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