The Ultimate Risk Management Tool: Equivalent Risk (Part 2)

07/13/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 1)

There are many ways to measure volatility; none are perfect and some are extremely complicated. For this exercise, I used a very rough measurement of the Average True Range (ATR), which is an average of the daily high minus the daily low, adjusted for market gaps. This measurement is available on all charting packages, and although it is a very basic measurement, it's a starting point (I do not use the ATR in my own position sizing and money management calculations, but as I said, none of these measurements are perfect and this exercise is meant as a starting point.)

It's easy to compare the volatility of these two stocks: Simply take the average true range and divide it by the price of the stock. By this measurement, Apple has an ATR volatility measurement of 0.0344 and ADM has an ATR volatility measurement of 0.0230. If you've seen charts of these two stocks, it shouldn't surprise you that Apple is a more volatile stock. But adjusting just the amount of cash you invest in each stock so that you have invested an equal amount of cash doesn't reflect the differences in the volatility of the two stocks. And if we add instruments like exchange traded funds (ETFs) and futures and cash forex to the things we might trade, the volatility becomes extremely important, though most retail traders don't understand they are not accounting for the different volatility of the instruments they trade, nor do they change their position sizes according to the volatility. Let's look at a series of simple Excel spreadsheet examples that will show you how to get started measuring the volatility of the instruments you are trading and how to compare them—and then enter into positions that expose your account to similar, if not equivalent risk.

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Let's start out with an Excel spreadsheet and a handful of popular instruments: AAPL (a stock), GLD (gold ETF), SPY (basically a closed-end mutual fund that allows you to buy and sell the stocks that make up the S&P 500 Index in one simple trade—it preceded the ETFs of today, but functions about the same way), the CME E-mini 500 S&P futures (the most popular stock index future traded in the United States, it basically mirrors the cash S&P 500 Index), and the Comex gold futures (the most popular futures contract based on the price of cash gold listed on a United States exchange).

Let's take this diverse list of instruments and examine different ways we might try to get to the point where we are exposing our account to similar if not equivalent risk when we take a position in any of these instruments. Let me re-state the idea: When we take a trade in Apple, we want to expose our capital to the same amount of risk when we take a position in gold futures several days later.

Some of you may still be wondering why we want to try to expose our account to similar risks each time we take a trade: If you have a wonderful day or week trading Apple, and then have a losing trade in gold futures, if you are using equivalent risk and a good risk/reward ratio (the importance of which I have written about many, many times), you should still have a very nice profit when you net the outcomes of the two trades.

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More tomorrow in Part 3…

By Tim Morge, veteran trader and trading mentor, MarketGeometry.com

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