Can We Easily Quantify Level Of Risk?

[Bankbuster]

Trade Risk Analysis - Can The Level Of Risk Be Given A Rating?

The recent thread on 'Random Entry' has made me think a little more deeply about analysing risk associated with a potential trade. I work in a project management environment and risk analysis is a key tool for minimising the impact of hazards
inherent in large engineering projects.

There was some mention of low risk high probabilty entries on the 'Random Entry' thread. It's interesting to note that traders take the opposite side of a trade with identical entry setup conditions.

Is anyone willing to give an opinion on the following:

What constitutes a low risk high probability entry?

What are the critical factors that determine the level of risk?

Can the level of risk be easily measured and quantified?

What control measures are employed to eliminate or control the risk?

Why do traders take the opposite side of a trade?

Do any traders here actually measure/quantify risk level associated with a trade?

I consider the following factors critical in determining and controlling the level of risk associated with a trade entry:
Market direction, deviation from the norm, support/resistance levels, maximum likely adverse excursion, volatility, size of position, stop loss. These criteria are common to both swing and momentum trading and yet the perceived level of risk may result in opposite trade's being taken at the same moment in time.

I regulary read the Signalwatch daily commentary and I can't
remember the last time that the momentum trade system
used on this site had a decent winning trade. I use a system that combines swing and momentum trading and I find myself taking
the opposite side of the trade's described on the Signalwatch site. I believe that a simple system to quantify the level of risk would prevent the high number of losing trade's currently being exhibited by Ed Down's system.

Regards To All On This Forum

From

Bankbuster

 

[Trader333]

Hi BB,

I have also been thinking along the same lines as yourself with regard to how to assess the risk level of a trade before entry. I guess you will have seen the posts by Grey1 who never places a trade without assessing the risk and is a successful trader.

This is something that I am trying to learn more about so it will be interesting to see what others have to say about this on here. I note that you say you often take the opposite side of trades described on this site. Which trades are you talking of ? is it index trading, share trading or something else ?


Paul

 

[stevet]

the questions you propose are astute and on the money - but whoever would have the answers would take volumes to explain -and understanding the dynamics involved is exactly what makes the difference between a trader making money in the markets on average everyday and someone who loses - but the power of the human brain to analyse price in terms of value and sentiment makes it difficult ( not impossible) to replicate those rules into a computer program

it is also important to differentiate "risk analysis" into profit orientated risk analysis and protective risk analysis , the latter being far the greater used and naive in form but utilised to actually provide multiple small losses in order to protect capital, by not accruing large losses - a lot of small losses of course add up to a large loss! - real profit oritentated risk analysis is a whole different ball game

one easy answer to a question u proposed is that due to different objectives of the different participants in the markets, accept during a fast move when size is pulled, there is always someone to take the other side of your trade, and of course you cannot be right all the time in each trade, neither can anyone else, you just have to be right enough!

and a system has to have a simple basis - but complexity is simple to achieve, simplicity is comlex to achieve

 

[Bankbuster]

Paul. I was referring to the index trades on the Signalwatch web site.

Stevet. Thanks for the reply. My understanding of your reply is that analysing and measuring the risk associated with trade entry is complex and cannot be easily quantified in terms that could be replicated by a computer program. The reason for this is because the market presents us with information that is fuzzy, probabilistic, noisy or inconsistent. The human brain, in comparison to a digital computer, is highly parallel, flexible and deals easily with this type of information. In particular, the brain is much better at processing visual information such as that displayed by stock market charts. This leads me to the conclusion that most trades are entered on an intuitive basis rather than as a measured basis.

I would also appreciate your expanded view on 'profit orientated risk analysis'. My assumption is that you are talking about a strategy for managing a position taken in the market, as opposed to simply utilising a tight stop loss to cut the trade if the market moves against you.

BB

 

[stevet]

Bankbuster

there are two types of computer automated trading a) trading for profit and b) trading to protect capital by neutral trading strategies

a) can be approached from either a market trend perspective or arbing perspective, b) is an interlectually flawed concept

a) requires a key understanding of price movement which can not ascertained by just understanding technical or fundamantal market analysis

rules in the markets are only rules until they are rules

 

[Bankbuster]

Thanks for the reply stevet.

I was hoping for a more enthusiastic reply to my initial post from those traders on the 'Random Entry' thread that expounded the virtues and importance of timing trade entry.

I'm a little disappointed with the lack of response to my initial questions. I was hoping for some in depth discussion on this very important topic.

Regards, BB

 

[Trader333]

Hi BB,

I suggest you contact Grey1 as he has an excellent knowledge on the subject of risk analysis prior to trade entry.

Cheers


Paul

 

[Glenn]

Bankbuster
Regarding your starting post, I have briefly checked Ed Downs forecasts every day since he started them (1998). You're quite right about the recent losing run.
However I get the distinct impression that is is no longer Ed who is doing the forecast. Subtle changes in language and phrases suggest to me that one of his staff have taken over the reins. And whilst I have rarely disagreed with Ed's thinking in the past, I certainly have recently. To be fair, I also think that the Dow chart has not been an easy read recently. There are conflicting patterns and trendlines to interpret, and they are close to the major downtrend from way back.
In any case, as I assume you know, you can't trade the DOW directly, only derivatives of it, or the SB 'markets' on it.

Regarding the level of risk in a trade, if such a thing can be quantified, then the means must surely depend on known probabilities, otherwise you have no mathematical basis to work from.
If for example you take statistics on the success rate of a particular chart pattern, and then assume that this rate will continue, then you have a basis for risk assessment. Without such statistics to begin with, you have no foundation.

Comversely, you could take the view (for equities) that the amount of risk in a share is over 80% dependent on the higher level market which contains it. So rather than just look at the chart for the equity, you need to look at the higher levels of market and sector first. Movements in these higher levels have more can have more impact on share prices in general than effects related to the company itself.
As the saying goes "When the tide goes out in the harbour, the good ships go down along with the bad." and vice versa.

Regarding Ed's site, as you know he typically takes 10 point or breakeven stop-losses and 50~100 point profits (until recently!)
Quite often he can see a target price, either at a support/resistance level or calculated from consolidation theory. This fits well with a conventional view that the amount of potential reward in a trade must be at least twice the amount of potential risk. i.e. Another kind of risk assessment (and the one I use for indexes).

"Why do traders take the opposite side of a trade?"
One reason is because they are operating in different timeframes.
Another is that some people buy dips and others get spooked out by them. There are many more reasons.

Glenn

 

[Grey1]

What constitutes a low risk high probability entry?

Answer depends on what methodology you choose to control risk ..you can use any of followings

1) Options
2) Market neutral strategies .. No matter where market goes, the trades are hedged against each other.. This subject can be found under pair Trading ..
3) Statistical analysis . ( There is 95% chance that prices does not exceed by 2 SD From its VWAP )
4) Technical Analysis ( RSI, CCI and stuff like that)
5) Level2 (Find support/resistance on l2 screen if you can


What are the critical factors that determine the level of risk?

Answer.. Look into VAR … Value at risk

Can the level of risk be easily measured and quantified?
Answer:-- better to be eliminated all together by hedging ..If you are looking into single trade then you still can quantify the risk level based on its historical volatility

What control measures are employed to eliminate or control the risk?

Answer you can control risk by diversification and hedging ..

Why do traders take the opposite side of a trade?
Answers:-- To eliminate market direction…

Do any traders here actually measure/quantify risk level associated with a trade?
Answer:- Well, I would not enter a trade unless I knew it was a A) a good deal B) Had a good chance of winning..( National Lottery is a good deal but you have near zero chance of winning so you nearly always lose your stake.. heheheh ).. yes you can measure the risk level by knowing how far your price is from its VWAP


Hope this help

 

[Mayfly]

BB,

I think you’ll find that reading Van Tharp will help to clarify some or most of the issues for you. You can buy both books here: http://books.global-investor.com/pa...urce=SearchBooks&PageSize=20&Search=van+tharp

In the meantime, I think you’ll find more of the sort of thing that you’re looking for here: http://www.tradelabstrategies.com/index.htm - you can download the ebook, which is free and well worth devoting a couple of hours (at the very least) of your time to, IMO.

Alex Matulich’s site http://unicorn.us.com/trading/ is also very good. The documentation page on the Prosizer program gives a summary of the main risk strategies used to calculate the expectance of a trading system.

Some people may feel that the approach is too mechanical; but the trust is about putting the odds in your favour, or developing an edge, and this seems to me to be the right approach.

HTH

Cheers

Mayfly

 

[wanna-be]

BB,

My 2p's worth

What constitutes a low risk high probability entry?
- The holy grail of technical trading.

What are the critical factors that determine the level of risk?
- For the purpose of trading, my risk is the maximum amount of money that I can lose if I take no further action on a position. I.e. 100% if long without a stop.

Can the level of risk be easily measured and quantified?
- Yes. Taking the conservative view above, I know exactly how much I stand to lose if everything moves against me.

What control measures are employed to eliminate or control the risk?
- This depends on the type of trade. On some trades you can sit back and wait for your target or stop to be hit. Some trades require transformation, e.g. a bear spread trade that is losing money can be transformed to a bull spread trade.

Why do traders take the opposite side of a trade?
- Without a difference of opinion, there would be no market. Furthermore, just because a trader buys what you are selling, does not mean that viewpoints differ. E.g. a bullish trader might sell a call option to construct a covered write position, and another bullish trader may buy the call option to construct a long call position. So you have opposite sides of the trade, with reasonably similar views.

Do any traders here actually measure/quantify risk level associated with a trade?
- I do quantify this before each trade. As a result, I am more successful and I sleep better.


HTH

Harry

 

[Bankbuster]

Thanks to everyone for your great replies. Mayfly...I've read the Van Tharp book...it's good. Thanks for the links.

For what it's worth here is my take on risk analysis for a particular trade:-

KEEP IT SIMPLE

The questions were aimed at determining/controlling/minimising risk for a straight forward buy or sell trade of a stock or futures contract, e.g. SAP is one of my current favourites, it is a highly volatile German IT stock with a typical intraday range of 400 points.

Q1.What constitutes a low risk high probability trade?

A1.I don't believe this has anything to do with the method being used to trade. The answer is much simpler than that.
Low risk trade - buy at low value and sell at high value
High risk trade - buy at high value and sell at low value

Q2.What are the critical factors that determine the level of risk?

A2.Another simple answer to this one! The level of risk is determined by (a) potential loss and (b) probability of the trade going against you. The level of risk can be categorised in a matrix and my version is shown in the attached table below.
The risk levels are categorised as low, tolerable, moderate, substantial and intolerable.

Q3.Can the level of risk be easily measured?

A3.The answer is YES! I should have asked 'How' can it be easily measured. The potential loss can be measured by using volatility (ATR) and the current intrady high and low. A simple subtraction will give approximate maximum likely adverse excursion levels for the equity moving in either direction against it's current position. The probability or likelihood of the trade moving against your position can be measured by it's current level of deviation from the norm (I use simple SMA bands for this), and also by giving due consideration to the current, medium and long term market trend which can also be measured. Other considerations such as chart pattern analysis are far too subjective to enable any sort of measurement to be made, and TA indicators are no better than a 50/50 toss of a coin.

Q4.What control measures are employed to eliminate or control risk?

A4.The simple answer to this question is 'set a stop loss' to exit the trade if it goes against your position. Depending on the level of risk you can increase/decrease position size and even consider taking the opposite side of the trade if the risk level is substantial or intolerable. However, setting a stop loss is only a very small part of a trade management (exit) strategy which, in my humble opinion, is the real secret of successful trading. For example, if the risk is low or tolerable it does not make sense to set a tight stop and allow your position to be taken out because the next likely movement will be in your favour. You do not want to exit a buy trade at the bottom or a sell trade at the top. Exit strategy should be flexible by taking account of the risk level. In low to
tolerable risk conditions consideration should be given to adding to the position if you are offered a more favourable price, whereas moderate to substantial risk positions should have a rigid stop loss. The strategy should take account of a running profitable trade by increasing/decreasing position size or exiting/reversing at a profit target, all based on the changing risk level.

Q5.Why do traders take the opposite side of a trade?

A5.Numerous reasons for this I guess! Traders that trade with the trend, traders that trade counter-trend, traders that have a permanent bearish view, traders that have a permanent
bullish view, traders that trade breakouts and traders that trade swings, novice traders, bad traders, good traders and professional traders.

Q6.Do any traders here actually measure risk level associated with a trade?

A6.I would guess that most enter trades on an intuitive basis rather than in any risk measured way.

Regards to all BB.

 

[Trader333]

BB,

I am not sure I fully agree with your buy low sell high example. I have found that a substantial amount of money can be made using a strategy of buy high sell even higher or sell low buy back even lower.

It works particularly well on trending markets and is based on buying strength and selling weakness.


Paul

 

[Bankbuster]

Paul,

I don't disagree with you. Trading momentum breakout's with the trend is a proven method of profitable trading. However, the type of trading you describe does not provide the lowest possible level of risk. My risk matrix would suggest that the risk is in the moderate to intolerable class. In my opinion, a swing trade provides the lowest level of risk........

BB

 

[stevet]

heres a thought - what is the value of risk of the risk assesment being wrong, and the value of the risk assessment on the risk ..........

ain't making moeny in the markets a bummer!

but one sure fact is, that the less experience you have, the more postitive value you will add to any risk analysis profile

 

[Bankbuster]

LOL.......stevet, your thought is a very good point because the probability of any risk assessment being incorrect must increase with respect to the level of inexperience of the trader carrying out the assessment (and I'm an absolute novice in comparison to yourself), which conveniently links to my next question to you.

How does a very experienced trader, like yourself, risk assess any one particular trade (e.g. buying S&P future contracts)?

Regards, BB

 

[Grey1]

BB

High and low are relative values and only make sence if you compare them to X bar back .,, X is a function of time frame one uses for trading and more and less depnends on your style of trading..

There for if X bar back is your bench mark for high /low then you must adjust your position size to make your trade worthwhile should you win your trade.. ( have you heard of that statement " the operation was succesful but the patient died ".. you donot want to get engaged in a trade with little outcome .. SB traders avoid scalping other wise you be toast sooner or later )


Risk..

The root of all losses is getting the market direction wrong ..If you can time the market direction then you are not far from making a million here and there ( Not many can ).If you get the market direction wrong even buying and selling High or Low wont help you ..The best way to reduce risk therefore would be to use some kind of hedging process ( Diversification , Pair trading , sector hedging ,Arb trades,....) and stuff like that.. Look under market neutral strategies..

There is alot to be said about risk process. Thank God we are in internet age and have access to all this info for free..

 

[Bankbuster]

Grey1,

I don't disagree with you on the point of low/high value being directly related to the methodology used, but your initial response didn't really answer the question 'what is a low risk entry?'. My answer was an attempt at giving a simple initial definition as a basis for my own risk analysis process. A refined definition might be 'buyng low value or selling high value in the direction of the medium term trend'.

Hedging is one possible control measure to minimise the loss (and therfore reduce the risk level) if the risk is calculated to be moderate or intolerable, however, I'm not a big fan of 'market neutral strategies'.

All the best, BB

 

[Grey1]

BB,

A low risk entry would be going long of stocks that are 2SD away ( below) from their VWAP on a strong day... There is more than 95% chance that the instrument will revert back to its VWAP .. If it deviates more than this limit it often has no volume back up and sooner or later will revert back .

I think IB offers trading at VWAP but not tried it yet..

 

[al-motor]

Grey T -

Interesting to hear the 95 % rule which ii can vaguely remember from my Stats classes- but at the time was not too sure about its practicality-

I have been looking for true edges in the mkt- one of them which i was trying was volume in the futures mkts ( ES, Dax, and even t bonds)- but could not spot much consistency-

you talk about VWAP , which i think relates to stocks, but actual measurement of that and also applying the 95 % rules seems quite complicated to put into practice............Any easy ways of doing this ??