I.13. The concept of risk in trading. Risk calculation.

Like any type of business, trading is associated with the concept of “risk”. Risk is the possible consequences leading to a decrease in your cash account caused by unplanned price movements and not taking this into account in your trading strategy (if there is one at all). We will try to deal with this issue in more detail, since this is probably the most important issue in any business.

However, in such books there is too much mathematics incomprehensible to the average reader. Let’s explain with examples exactly how to assess the risk and what it may be associated with.

The following possible risk calculation tools are available in foreign literature:

The coefficient of profitable trades that takes into account your analytical capabilities. If this coefficient falls below 65%, then this gives a guarantee of ruin:

where  К_пр.рп- the number of profitable transactions during the billing period,  К_сд- total number of transactions during the billing period.

The break-even ratio shows whether you are losing more than you are winning. The coefficient value must be greater than zero:

where П – amount of profit, У – amount of losses, С – standard spread (the difference between the highest and lowest price), К_у.с.- the number of unprofitable transactions during the billing period.

A generalizing indicator of the trader’s activity. It shows the overall success of the trader’s work, consisting of his ability to analyze the market and make the right decisions about opening or closing transactions:

The value must be above 1.

The following risk assessment methodology is widely used in domestic trading practice. A short formula is proposed, which is the ratio of profit to loss, normalized relative to losses, for example, 3:1, meaning a threefold excess of profit over loss. It is believed that a more qualified trader can use a 5:1 or even 10:1 relationship.

For example, you set a standard risk limit in the form of a loss of 0.5% of the amount that you plan to use in the transaction. For example, you want to buy shares of Sberbank in the amount of 100,000 rubles. Then, according to the 3:1 model and the selected risk limit of 0.5%, we get that you estimate the maximum loss in this transaction as

100,000 * 0.5% = 500 rubles, and the maximum possible profit of 0.5% * 3 = 1.5% or 100,000 * 1.5% = 1500 rubles.

This means that you are ready to lose 500 rubles for the sake of earning 1,500 rubles.

In some systems, it is proposed to limit the risk level even more to 0.2%. Then for the above example. We will receive a maximum loss of 200 rubles in exchange for the hope of earning 600 rubles. As you can see, risk assessment is an extremely subjective value and is determined by practice. On our own, we note that the level of risk significantly depends on the volatility of the instrument and can vary widely from 0.1% to 10%.

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