How To Manage And Measure Risk If Volatility Is Not It?

Discussion in 'Risk Management' started by ironchef, Nov 5, 2018.

  1. ironchef


    This is the most troubling and nagging question I have since day one. It is especially troublesome after I became a "full time trader": Should I embrace volatility? How should I define risk in my model? Is trading volatility similar to trading risky instruments?....

    Basically I am a Beta trader, trying to capture higher returns by trading higher Beta instruments, etc. If volatility is not risk, then there is hope that as a volatility (Beta) traders I can achieve long term success, if it is a good proxy for risk then I am doomed. Am I fooled by volatility/randomness?

    Any comments and guidances will be appreciated.
  2. Robert Morse

    Robert Morse Sponsor

    I can't answer that for you.
    Yes through sizing your trades based on your account size, expectancy of profit and planning your exits.
    IAS_LLC, wrbtrader and ironchef like this.
  3. get sober.
  4. wrbtrader


    Is trading volatility similar to trading risky instruments?

    I like to add that the two (trading volatility / trading risky instruments) are independent of each other.

  5. Best way.

    1. Decide in advance how much you're willing to risk that your bet is correct. Place a hard stop there.

    2. When volatility is higher, use a wider stop. Reduce position size as/if necessary.
  6. tomorton


    Volatility is a major risk and using a volatility-based stop-loss is one way to respond, setting a stop at say 2 x ATR20 out from entry, or using TA to find a suitable s/r level which is not less than 2 x ATR20 out.

    But this sort of risk is amplified for swing or reversal traders or chart pattern traders because once you're been stopped out that's probably the end of that set-up.

    In long-term trend-following on the other hand, if you go long at 2000 and price drops to 1900 and you get stopped out, then the sooner you're out at 1900 the sooner you can get back in at 1901.
  7. ironchef


    I appreciate your response sir.

    there has to be other ways of defining risk? If I use volatility (standard deviation) as a proxy for risk, like most financial studies, then the two sets of data has the same risk because they have the same volatility as defined by standard deviation? Obviously an investor who is able to select "E" will do better than one that select "D".


    Following the same logic, if I were to analyze RUT and SPY over a 20-30 year period, one is consistently growing faster than the other but with higher volatility. My logic says I should select RUT rather than SPY if I have a long time horizon. What would you do?
  8. ironchef


    How would that help?
  9. No, SPY has a higher risk adjusted return (Sharpe Ratio). Select SPY and leverage it up to RUT vol. Your returns will be higher for the same risk (vol). Financing should not be an issue, if you can't leverage (borrpw) at broker call, then near-risk-free-rate financing is build into the ES premium/discount.

    This is Modern Portfolio Theory 101, you need to read up on it until you have a good understanding.
    Magic likes this.
  10. ironchef


    Thank you for taking the time to answer and for your coaching. Yes, I admit, for someone without a formal financial education, I am quite confused.

    My main question: Is volatility a good proxy for risk?

    You said volatility = risk. So, if SPY has a Sharpe Ratio higher than Russell, then it trumps RUT.

    Let me ask you another question: If I can find an instrument that exactly mimic SPY but has a volatility and return 1.5X SPY. For my retirement fund that I won't touch for 30 years, would I put that in SPY or 1.5X SPY? You say it is the same. I, being non financial say I put it in the 1.5x SPY because over every 30 years, the odds of SPY going up is quite good so my odds of getter better absolute return is quite high and worth the "risk"?

    #10     Nov 10, 2018