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Risk Management

Measure, Control, Hedge

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Risk Management Summary

The biggest problem with most investors is they have no idea how to measure, control, and hedge risk. Risk management in the markets is direly important. Many investors and traders know how to make money, but often have no idea how to stop themselves from handing it back to the market. They often find themselves suffering massive eventual losses.

The goal of this section is to educate you by introducing a substantial number of risk management techniques and metrics. Academic and quantitative approaches to measuring risk will be discussed, explained, and diagrammed. Lastly, various ways to hedge risk will be introduced. This will help you make investments while limiting your downside and preventing meltdowns in your account.

Risk Management

Major Economic Analysis

Economic Summaries
Statistical Currency Projections
Large Speculator Sentiment
Technical Signals Lists

American Equity Markets

Economic Performance Index
US Dollar Projections
Market Sentiment Tracking
Sector Strength Tracking
Consensus Estimate Rankings
Fundamental Firm Analysis

Risk Statistic Concepts

Your ability to measure risk is based on a fundamental understanding of statistics. Don’t worry. The comprehension of statistics required to competently measure risk in trades before you make them is minimal and very rudimentary. Understanding statistics will help you learn a variety of metrics that allow you to control exposure. It’ll help you filter out bad trades and monitor your true ability to trade or manage a portfolio.

Return Distributions and Risk

Return Distributions and Risk

Distributions count the amount of occurrences within a series of returns at different intervals over a period of time. For investment returns, it counts the amount of returns split into percentage ranges. It creates a graphical representation, organized by stacking columns. More height equates to more occurrences in each column. The higher the amount of occurrences within a probability range, the higher that part of the visual distribution. This creates a probability distribution, or how likely a certain event is going to occur based on historical data. When assessing risk, you should prefer more columns are in positive return distributions and higher than the negative return distributions, since the negative distributions are your historical risk of loss. You especially want the total average return to be in positive territory.

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Standard Deviations

Standard Deviations

Standard deviation is equated with risk but is also equated with the predictability of future returns. A higher standard deviation is associated with higher amounts of risk, while a low standard deviation is associated with low risk. This is true and false. You can have a low standard deviation and constant losses, and high standard deviation with constant gains.

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Skew & Kurtosis

Skew & Kurtosis

Skew and Kurtosis have been highly overlooked statistics by private/retail investors. Ignoring skew and kurtosis ignores the nature of your return’s distributions. The skew of a distribution measures asymmetry of distributions around a mean. If it’s a positive distribution, a non-symmetric tail extends into positive values. If negative, the tail extends into the negative values. Prefer investments with a solidly positive mean, and thin tail going into the positive with little or no negative tail.

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Covariance & Correlation

Covariance & Correlation

Covariance indicates if two separate variables tend to move in the same direction together over a specific time frame. In investments, covariance shows if two separate assets move together. Positive covariance indicates yes, while negative covariance indicates no. Correlation indicates the degree or strength which they move together. If two separate assets have 100% correlation, they will move together in perfectly equal degrees. If they have 0% correlation, there is no relation between them. If they have -100% correlation they will move perfectly opposite to each other. If seeking diversification, reduce the positive correlation of assets within the portfolio, then you’re not at risk of taking losses from all assets at once.

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Risk-Adjusted Return

Looking at returns as a raw percentage is deceptive. A trade should not only be measured by the amount of money it made you or the percentage return you gained from the trade. The true measure of success is a high measure of Risk-Adjusted Return. The higher your risk adjusted return, the lower the amount of risk you took to make a higher return, and the more skilled you are as an investor or trader.

Sharpe Ratio

Sharpe Ratio

The Sharpe ratio is an important and common risk-adjusted return statistic. It subtracts the risk-free rate from the average return, then divides that by standard deviation of returns. It’s easily compared across multiple asset classes since it normalizes return by the standard deviation.

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Sortino Ratio

Sortino Ratio

The Sortino ratio attempts to fix problems found in the Sharpe ratio. Extreme upside volatility decreases the Sharpe ratio but is beneficial to investors. Upside volatility shouldn’t punish risk-adjusted returns since it’s not a risk. Another benefit of the Sortino ratio is it uses the minimum accepted return instead of the risk-free rate.

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Omega Ratio

Omega Ratio

The Omega Ratio is another very different take on the Sortino Ratio. Omega totals all of the probabilities exceeding a minimum acceptable return and divides by all the probabilities beneath a minimum acceptable return. The result is the chance you’ll hit the acceptable return or beat it.

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Volatility & Stop Losses →

Measuring Volatility in an asset is important for multiple reasons. The higher an asset’s volatility, the greater its price swings. Volatility is constantly changing, which is why you look at an asset’s volatility over multiple seasonal periods and market cycles. Having a wider idea of an asset’s volatility historically and recently gives you an imperfect idea of what you can expect from the asset in the immediate future. Volatility should definitely be considered when setting stop losses.

Average True Range & Volatility

The average true range (ATR) is a measure of the volatility of an investment. But before we discuss ATR we must talk quite frankly about volatility, which is essentially how drastically an asset’s price can change over a period of time. Volatility is often believed to be the risk of an asset, with higher volatility environments being riskier. This is and is not true.

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Setting Stop Losses

Traditionally, most retail traders and investors utilize the principle of a “stop loss”. Stop losses place an order at a specific price level that will automatically close a trade if the price reaches that value. A stop loss on a purchase will be a sale to close the order at a certain price. Traditionally traders set this stop below the most recent swing low.

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Beta, Alpha, & Regression

Measuring a potential trade’s risk against an existing portfolio is testing the asset against a benchmark. The benchmark is usually either an existing portfolio, a market index, or a basket of assets. When measuring an asset relative to an existing portfolio you can see how your potential trade affects existing risks. It can either concentrate and increase existing risk, or reduce and diversify existing risk. It can also add potential performance relative to risk or reduce potential performance relative to risk.

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Drawdowns & Calmer Ratio

Drawdowns are a measure of previous loss from a peak to a low and back to the same price as the old peak, moving from left to right. The old peak is known as the recovery point. Once the recovery peak is met or exceeded, the drawdown is complete. The size of the drawdown is measured from the latest highest peak to the bottom of the trough.

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Confidence Level

The confidence level is an estimated range likely to include a value. The confidence level, in terms of returns, is the value at a return percentage. There are multiple statistical tests that will give you the specific value when you arrange the asset from best to worst, or from worst to best. The return at the 90%, 95%, or 99% level is selected and then used to measure risk.

Value at Risk

Value at Risk

The Sharpe ratio is an important and common risk-adjusted return statistic. It subtracts the risk-free rate from the average return, then divides that by standard deviation of returns. It’s easily compared across multiple asset classes since it normalizes return by the standard deviation.

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Expected Shortfall

Expected Shortfall

Expected Shortfall is an important metric that reveals information not included in Value at Risk. It’s also called Expected Tail Loss, Conditional Value at Risk, or Average Value at Risk. While Value at Risk gives you the loss at a confidence level (the 90%/95%/99% worst return from an investment) it doesn’t tell you what normally happens if you exceed it. Expected Shortfall tells you what the expected loss would be if you exceed a Value at Risk confidence level. It simply averages the returns beyond the confidence level.

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Rachev Ratio

Rachev Ratio

The Rachev-Ratio takes the expected tail return and divides it by the expected tail loss. Since its dividing expected return by a measurement of risk, higher is always better. In all cases, use the same time period to get accurate results.

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Options Hedging

There is an alternative technique to stop losses known as “Options Hedging”. You can have 24/7 protection against an adverse price movement that won’t trigger early if you’re exposed to a long purchase or a short sale. Options Hedging is an insurance technique that will cost money, increasing the cost of the trade and requiring more overall price movement for gains in exchange for limiting losses. You’ll purchase a derivative option as a hedge.

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Handling Portfolio Margin

Portfolio Margin is a completely optional risk which can drive you deep into debt if you are careless or greedy. If you open a margin account, your broker lends you money using your deposited account capital (and any resulting trade positions) as collateral. Equity margin is SEC limited to 2 times deposit in the USA. As you exceed your deposited capital and use more margin, you increase the amount you gain and lose per trade.

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Risk Management

International Economic Analysis:

  • Major Currency Economic Summaries
  • Performance of Major Imports and Exports
  • Mandates of Central Banks versus Expectations
  • Performance Indexes of Major Economies
  • Economically Correlated Currency Projections
  • Large Funds Currency Sentiment Readings
  • List of Technical Indicators to Look For
  • Occasional: Foregin Exchange Technicals Markups

Risk Management

American Markets Analysis:

  • Summaries of American Economic Structure
  • Performance of Major
  • Imports/Exports
  • Federal Reserve Mandate versus Expectations
  • Performance Indexes of U.S Economy
  • Economically Correlated U.S Dollar Projections
  • Large Trading Fund Index Sentiment Readings
  • Market Wide Earnings Versus Valuations
  • Fundamental Ranking of U.S Business Sectors
  • Best and Worst Future Consensus Estimates
  • Occasional: Firm Fundamental Strength Report
  • List of Technicals to Look for While Trading

Risk Management

Brokerages, Insurance Firms,
Financial & Trading Software.

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