The Ultimate Risk Management Tool: Equivalent Risk (Part 4)

07/15/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 3)

Now let's start building the calculations that will allow us to compare risk. I'll begin by assuming we are trading 10,000 shares of stock each time we make a trade, or 10,000 futures contracts. Let's see how that works out numerically:

chart
Click to Enlarge

Just glancing quickly at the row marked “Dollar Risk on Position” should be an eye opener for those of you who always trade the same number of shares each time you trade various stocks or trade the same number of futures each time. For example, if you trade 10,000 shares of Apple (AAPL), using the ATR method, you are risking $86,000 if you bought the high and sold the low of the day as projected by the ATR (this assumes you are not using stop loss orders to limit your risk or that your stop loss order is larger than the ATR projected move for the day). If you traded 10,000 shares of the ETF GLD, you would be risking $20.000. These risks are not equivalent, and it gets even more striking if we compare the risk associated with taking a position of 10,000 shares of Apple stock and 10,000 E-mini S&P futures. You'd be risking $86,000 on the Apple position and $9,000,000 on the E-mini S&P futures position. That's an incredible difference in risk!

I'm not suggesting the majority of traders, or even a few traders, are out there trading 10,000 shares of Apple stock and making the assumption that they are taking the same risk when trading 10,000 E-mini S&P futures. But I am suggesting that the majority of traders have not done an exercise like this and really don't have any idea how the risk on each instrument they trade compares. And it is something each trader needs to know if they trade multiple instruments.

chart
Click to Enlarge

So let's build a new set of calculations and see if we can come with something that approaches equal risk for each instrument we trade, each time we take a position.

chart
Click to Enlarge

By taking the ATR of an instrument and multiplying it by its dollar value, or one point value and the maximum stop loss I am willing to use for that particular instrument, we can easily generate a standard measurement of risk for each instrument. We can then use that standard risk measurement to compare the riskiness of one instrument as it compares to others.
More tomorrow in Part 5…

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

Related Articles on STRATEGIES