In this piece I would like to present my view on the fundamentals of risk management. To be entirely honest, I’m yet to really crystallise the definition of risk in my head yet, so please bear with me as I try to do so now. Well, it seems traditional finance likes to define risk as volatility. But that’s not quite accurate for everyday use is it? I mean I’ve yet to hear anybody complain about UPSIDE volatility. If a strategy never lost a cent, but tripled in short order occasionally, the volatility would be off the charts, but I’m not sure I’d say it was risky if it never lost money. So this definition is not quite complete.
So is risk the probability of losing money then? Surely if you can make money 99 times out of 100, then that’s a great low risk strategy? What if I said we could make $1 each time we won, but lose $1 million each time we lost, would that not be risky? So clearly risk is not something that just looks at the chance of something occurring.
In the above example we talked about the consequences in dollar terms of winning and losing. Ah, so that must be a component of risk as well then, surely? Because the 99% accuracy bet sounded good until we mentioned how much we would lose, didn’t it?
So perhaps we can break risk down into three components:
1) How much money we can lose (the magnitude of losses),
2) How likely we are to lose money (the probability of losses) and finally,
3) Volatility (the ‘path’ my portfolio performance takes to achieve a return. If it goes up and down in big swings to achieve 10%, surely it is more risky than a portfolio that is fairly stable but achieves the same return?)
Welcome to the Classical Charts and Swing Trading blog (The CCST Blog), where I am documenting my trading journey and the lessons I have learnt so far. For more content, please visit my blog at https://exchange.realvision.com/post/ccst-blog-table-of-contents-please-see-links-to-each-post-in-the-comment-se--5f5ea1e8f8e9773f2bf1cf1e
A big goal for this blog is to become a place where like-minded traders can interact, learn from each other, share their experiences and help each other along their journey. So I would really like to thank those of you who have taken the time to read through my blog posts, and even left a like or a comment. Although I mainly write to increase my own thought clarity on trading, it does motivate me to know that there may be a reader or two out there who enjoys my writing and I hope you'll share your journey with me as well!
DISCLAIMER: I am not giving financial advice. I'm a full time engineer, not a professional finance guy, so please do your own research!