The Ultimate Risk Management Tool: Equivalent Risk (Part 3)
07/14/2010 12:01 am EST
We've already discussed this and the obvious conclusion is that the price of the instrument does not necessarily relate to its value, especially when comparing it to other instruments. Let's keep building our spreadsheet.
Now we add our first measure of the volatility of each of the instruments we are going to compare. There are many ways to measure volatility and many ways to use these different measurements. For example, a very short-term trader may not be interested in knowing that there are occasionally out-of-character spikes in price in the instrument he or she trades every five or ten years on weekly bars because they are focused on five-minute bars. (These events are called “Black Swan” events, and although most people believe these events occur about once every 100 years, the measurements simply predict that in the case of normally distributed data, roughly one in 22 observations will differ by twice the standard deviation or more from the mean, and one in 370 will deviate by three times the standard deviation. They are of much greater interest to portfolio managers or traders who hold positions over long periods of time. I use a longer-term approach to calculating my measurement of risk and volatility, so I do take into consideration these third-deviation moves.)
But for this exercise, using a 20-period average true range is a good start for our volatility measurement of each vehicle. Begin with this measurement and you can always choose to replace it after you work with it for some time and learn about other methods and their strengths and weaknesses.
To do any calculations, we'll need to know both the current price of the instruments and the value of one dollar in a stock (of course, one dollar in the United States is worth one dollar) or one point when trading futures (one point refers to a move from 1075.00 to 1076.00 in the E-mini S&P futures; it refers to the move from 1250.00 to 1251.00 in the gold futures). These values are assigned by the exchanges.
I never trade without entering an initial stop loss order into the market at the same time I enter my entry order; I want my capital protected at all times. I have a maximum-sized stop loss I use based on my research of the a combination of the volatility of the instrument, as well as how far each instrument can trade past market structure roughly 80% of the time and still return to the major trend. Some people feel this is a redundant measure of volatility, but it is a number that relates to my own willingness to risk a certain, maximum amount of capital for each instrument based on its trading characteristics—do not confuse this with the average true range, for instance. I add the size and value of my maximum stop loss for each instrument I trade so I can compare what I am risking.
More tomorrow in Part 4…