How to Measure Risk
May 1, 2018, 11:31 am
I get a lot of questions about risk, and for good reason. Nobody likes to lose money, especially big losses that can set you back and take time to recover from. Higher-percentage losses can be more acceptable in certain kinds of trading, such as options, where traders should have smaller amounts of capital at stake per trade. But when it comes to stocks, where you may have bigger amounts of capital invested per trade, it’s important to measure and consider risk in your trading.
Risk management is a term that many individual investors hear but don’t fully understand. It can range from the straightforward, such as having set entry and exit points, to complicated formulas designed to measure risk mathematically.
Here are some ways to measure risk that you may have heard about:
1. Volatility: The most widely known measure of volatility in the overall market is the VIX, which is an index at the Chicago Board Options Exchange that determines implied volatility on the S&P 500 based on activity in options. For individual stocks, one measure is the beta, which compares the stock’s movement to a benchmark index. For example, the S&P 500 would have a beta of 1, and if a certain stock has a beta of 1.5, it is about 50% more volatile than the index as a whole.
2. Value at Risk (VaR): This metric is widely used by hedge funds and institutions. There are different ways to calculate it, but it is essentially a way to figure out what a worst-case scenario would look like for your portfolio over a specified period with a high degree of confidence.
3. The Sharpe Ratio: It is also known by other names, such as the Sharpe index, Sharpe measure and reward-to-variability ratio. It’s more of a quantitative risk/reward measurement when comparing investments. The one with the higher ratio is presumed to be the better investment because you get either more return for the same risk or the same return but with lower risk than the other investment.
Risk management doesn’t have to be quantitative, though. In fact, it shouldn’t be. Mathematical formulas can be a big help, but not everything fits that neatly into a formula.
I consider a variety of factors when assessing risk, including valuation (using a number of different metrics), beta, volume trends, technical analysis and more. I also consider a company’s fundamentals, broader market trends, specific events such as earnings reports and more.
Limit orders can be part of a risk-management strategy as well, and this is another area I get a lot of questions about. Limit orders allow you to put a sell or buy order in place to automatically trigger based on your criteria. For example, if you want to buy a certain stock but only at a pullback to a specific price, you can set a buy order that automatically triggers at that price. On the flipside, you can put in an order to trigger a sell at a specific price to either take profits or cut losses. There are also more sophisticated orders such as trailing stops, which adjust higher as a stock moves up and trigger a sell when it pulls back a specified percentage or to a specified price.
Orders do have their shortcomings, though, including the fact that specialists can see them sitting there and play some games with the related stock. Therefore, I don’t use them all of the time, but they can be effective when used appropriately.
All in all, good risk management incorporates multiple strategies and tools. Our goal is to be smart about risk while maximizing returns.