volatility
As everybody knows volatility is a measure for average price fluctuations. In other words, it is a measure for average daily percentage change in closing prices. Many times “experts” use it as a risk measure by telling you that high volatility implies high risk. In my opinion this is one of the biggest mistakes in investment theory. Why?
Let’s take an example: in year xy some FX quote changed by 50% - up or down - and therefore displayed very high volatility, which means that this pair is now considered very risky to invest in. How can extreme movements with chances for huge wins result in high risk? It’s even more obvious with stocks. Why can a stock that rose by 50% be considered very risky? See the problem? Risk theory treats upward and downward movements in exactly the same way. So if you just look at volatility data, you will not know if a currency pair or stock doubled its quotation or if it went down by 50%.
So if volatility is no good when measuring risk, what is volatility good for and how can risk be measured effectively? In my opinion risk is never a characteristic of a certain stock or forex quote, it is a characteristic of the model you use to predict price movements. Lets assume an extreme case:
You possess a prediction model or a crystal ball which enables you to forecast price movements with an accuracy of 100%. What are you going to invest your money in? Certainly in the most volatile currency pair or stock you can find since the high daily price movements will help you maximize your profits. How about an accuracy of 60%? Same answer! If you can be sure that 6 out of 10 trades are “right”, no matter if selling or buying, you will end up with more money if you invest in very volatile than in less volatile currency pairs/stocks. As you can see the risk lies in your predictions. How about an accuracy of around 50%? By investing at 50% accuracy level you might win, but you might as well lose. If you invest in highly volatile stock you’ll win/lose more than when investing in low volatility stock. This is basically all volatility is about - the LEVEL of gains/losses - not the FACT, if you win or lose. The FACT is always caused by your prediction quality.
However, who would invest with a 50% model? I would not. You might as well play roulette. The first thing is to find a prediction model with high accuracy, then you pick high volatility currency pairs or stocks which you can forecast at that high accuracy level. To spread risk you invest your money in more than one stock/pair, probably 5 to 10. This will help you keep off ugly surprises. As shown above, low volatility won’t help you reduce risk. It is going to help reduce losses if you suffer them. With good predictions this won’t happen.
If you intend to follow a buy and hold strategy the problem is a totally different one: you have to find a currency pair (=a country and/or its economy) or a company with good prospects for the future. This doesn’t have anything to do with volatility! It is a matter of fundamental data, industry outlooks, technological development, politics etc. So no matter how you look at it: as a day trader or as a long-term buy-hold investor - volatility NEVER is a measure of risk. I perfectly well know that this is hard to get out of peoples minds but I certainly hope to make some readers think about this problem. If they do, they’ll find out that textbook wisdom on investment theory is definitely wrong in this point.
risk has its origin in the quality of your prediction model. no matter which technique you use. so the question is: how can you handle or minimize risk in real trading situations? an absolute “must” is to decide which percentage of your money to put at stake with each trade. at neuralFX we prefer a rather aggressive approach and risk 3% per day. when trading 3 currency pairs then for each one stop loss (s/l) is set at 1% of total account volume. please make sure to know the exact pip values of each pair. these do differ significantly.
in detail the procedure works as follows: you calculate the 3% and devide this amount by the number of currencies traded. based on volatility data on each currency pair you set an appropriate s/l in terms of PIPS!!! the pip gap between current quote and s/l has to be translated into your 3% of account balance share. this is done by varying “leverage” which each trading platform offers.
example: 100k account - 3 currencies traded - s/l €1000.- each. let’s assume that pair nr.1 has a reasonable s/l at 50 pips and that one pip is worth €1.-. (this reasonable s/l is derived from volatility data and your trading method, here we want to demonstrate the basic mechanism of limiting risk which is valid for every trading strategy.) consequently your leverage for this pair is 20. 20*50=1000. when you get killed in this contract your loss will be €1000.-. not more. not less. the emphasis of each risk limiting strategy has to be on setting s/l at the pip-distance your model tells you to. the percentage value regarding account volume is reached via the leverage factor.
as regards limiting risk inherent to your trading model the keywords are backtesting and honesty towards yourself. test your model on various time frames, on various pairs, with various parameters etc… if the model produces losses in backtesting then either find ways to improve it or throw it straight away. this might be hard to do since it means admitting that the model is worthless and your approach is wrong. but if you stay stubborn and employ your strategy in real life hoping that it’ll work you’ll most likely end up with an empty trading account. this leads to one more important aspect of trading and risk control: trading psychology.
psychology
apart from a good trading model your own psyche is the most important trading tool. never underestimate its influence on your trading results. one of the hardest things in trading is to eliminate two fundamental human emotions: greed and fear.
each one of these emotions will make you lose money even if your trading model is a good or even excellent one. here’s an example of my experience with client: a client purchased a one year subscription of our forecasts and started trading them 1:1 as we did on our managed account. fortunately the first 3 months went extremely well and we madde around 30% with a daily risk exposure (daily s/l) of 3% of account balance. what happened then? the guy became greedy and raised his risk exposure to 20%!! a day. after 2 bad weeks he was broke even though we finished the fourth month at +/- 0.
the lesson to learn is very simple: greed kills. no matter how good your trading system is you have to forget the idea of getting the absolute maximum out of it. if this approach really worked every trader would be a millionaire. this is clearly not the case. most FX-traders go broke instead of becoming rich. your job is to set yourself strict rules regarding daily risk and to stick to them no matter what happens on your trading account.
this leads to the next emotion which you better turn off: fear. fear doesn’t kill you the same way greed does but it makes you miss opportunities. when you start trading and have a few bad months then please never ever lower your risk exposure. why? if you still DO believe that your trading system is a good one then there’s no reason to lower risk exposure. this would simply reduce your future profits. (btw: there’s no trading system in the world which doesn’t/didn’t make losses over a longer period of time - the crystal ball doesn’t exist). if you DON’T trust your trading system anymore you better stop trading completely and take your time to adjust and further develop your system or find a new approach. lowering risk exposure in this case would help reduce your losses. but who wants losses in the first place? better to quit trading until a better system is found.
all of this might sound very basic and simple to you but i do know that these emotions are really dangerous and that it’s very hard to turn them off completely. which you will have to do when you want to become a successful trader. an alternative would be to invest in a manged account - which we do offer 
- and trust the skills of professional traders. no matter how you decide you already have come half the way by being aware of emotional dangers.
juergen