risk and risk aversion
Talking with investors I find the more time I spend educating, training and supporting FOREX traders, the more I come to realize the less the average trader knows. It’s not a trader’s fault they don’t understand some of the technical nuances of the market or that they may not understand how and why currencies move during certain market conditions. The average trader just has not had the opportunity. I thought it would be fitting in this month’s article to take a couple minutes and explain one of the more commonly talked about topics for currency traders that they may not fully understand.
I’m talking about trader’s appetite for risk or need for risk aversion. Often when you refer to having an apatite for risk or looking at risk aversion you are trading currencies with a low interest rate like the JPY or CHF. When traders are looking for high return investments they are said to have an apatite for risk, they will often borrow YEN or CHF in order to obtain other assets they expect to gain a higher yield from; maybe from other currencies on carry trades or equities that are performing well etc. You may also hear traders refer to risk aversion, when we see a broad based pull back, traders will look to unwind those positions and buy back the YEN or CHF that was previously sold, causing the YEN or CHF to rally. Traders will unwind these more risky positions in order to limit potential losses.
Apatite for Risk and Risk Aversion are not only a financial or economic concept but psychological concepts as well, with trader’s emotions playing a big part in how they view risk. There are several concepts or theory’s traders’ use when evaluating risk. Now its time to break out the Macro/Micro economics books and look the mathematical basis and formulas trader’s use to determine Risk/Risk Aversion.
Traders often look at a Utility Theory; where a consumer has a utility function U(xi) where xi are amounts of goods or services used with an index of i. From this, it is possible to derive a function u(c), of utility of consumption c as a whole. Here, consumption c is equivalent to money in real terms, i.e. without inflation. The utility function u(c) is defined only as a liner transformation. The Utility Formula shows how traders analyze a situation for a risk-averse trade: The utility investment, E(u) = (u(0) + u(100)) / 2 is the equivalence of CE is the risk premium, Or ($50-$40)/$40 or 25%. Traders may also look to avoid all risk by analyzing the curvature of u(c), the higher the curvature the more adverse a trader becomes to risk. Traders need to be able to measure risk from an absolute or constant point called the Arrow Pratt measurement of Absolute Risk Aversion (ARA) named after economists Kenneth Arrow and John Pratt who gave us the formula for determining (ARA) from a constant point Ru(c)=-u”(c)/-u”(c) using the utility form of u(c) = − e − αc shows the constant aversion to absolute risk (CARA) with ru(c) = α is the constant with respect to c. IN order to have Decreasing/increasing absolute risk aversion (DARA/IARA) if Ru(c) is decreasing/increasing. An example for a (DARA) utility function is u(c) = ln(c),Ru(c) = 1 / c, while u(c) = c − αc2,α > 0,ru(c) = 2α / (1 − 2αc) would represent the utility function exhibiting (IARA). Contrary to what many traders may believe having capital in your trade account does not make one adverse to risk.
Traders looking for theories on Relative Risk Aversion most commonly known as (RRA) is defined as a corresponding term with Constant Relative Risk Aversion (CRRA) and Decreasing/Increasing Relative Risk Aversion (DRRA/IRRA) look for the advantage of the value of measured risk aversion, if your apatite for risk changes and allows for higher risk tolerance, look at the coefficient for Relative Risk Aversion as c with u(c)=c1-p/1-p your risk aversion is now R/u(c)=P when P=1 this will simplify the log utility income effect on savings.
Traders may also use what is known as a portfolio theory, this allows traders an aversion to measured risk as additional margin rewards required to assume additional risk. Using the Portfolio Theory risk is measured as the mean or standard deviation of the return on investment. The Square root of the variance is measured to the n-th degree also know as the (radical) using A or An. Or A=dE(r)/dq or An.=dE(r)/dn.overUn.=1/n dE(r)/dun.
Too put this into practice terms and use, traders may limit there inherent risk exposure by utilizing good money management with appropriate risk to reward ratios, using risk capital will help limit the psychological affects of risk and risk aversion. You may also implement any risk or risk aversion formula into your trading thus limiting the risk premium; I personal use a formula of (account balance times percent of acceptable loss divided by the number of pips in my stop equals the number of lots I can trade.) simple but effective.
Adam Horak
I’m talking about trader’s appetite for risk or need for risk aversion. Often when you refer to having an apatite for risk or looking at risk aversion you are trading currencies with a low interest rate like the JPY or CHF. When traders are looking for high return investments they are said to have an apatite for risk, they will often borrow YEN or CHF in order to obtain other assets they expect to gain a higher yield from; maybe from other currencies on carry trades or equities that are performing well etc. You may also hear traders refer to risk aversion, when we see a broad based pull back, traders will look to unwind those positions and buy back the YEN or CHF that was previously sold, causing the YEN or CHF to rally. Traders will unwind these more risky positions in order to limit potential losses.
Apatite for Risk and Risk Aversion are not only a financial or economic concept but psychological concepts as well, with trader’s emotions playing a big part in how they view risk. There are several concepts or theory’s traders’ use when evaluating risk. Now its time to break out the Macro/Micro economics books and look the mathematical basis and formulas trader’s use to determine Risk/Risk Aversion.
Traders often look at a Utility Theory; where a consumer has a utility function U(xi) where xi are amounts of goods or services used with an index of i. From this, it is possible to derive a function u(c), of utility of consumption c as a whole. Here, consumption c is equivalent to money in real terms, i.e. without inflation. The utility function u(c) is defined only as a liner transformation. The Utility Formula shows how traders analyze a situation for a risk-averse trade: The utility investment, E(u) = (u(0) + u(100)) / 2 is the equivalence of CE is the risk premium, Or ($50-$40)/$40 or 25%. Traders may also look to avoid all risk by analyzing the curvature of u(c), the higher the curvature the more adverse a trader becomes to risk. Traders need to be able to measure risk from an absolute or constant point called the Arrow Pratt measurement of Absolute Risk Aversion (ARA) named after economists Kenneth Arrow and John Pratt who gave us the formula for determining (ARA) from a constant point Ru(c)=-u”(c)/-u”(c) using the utility form of u(c) = − e − αc shows the constant aversion to absolute risk (CARA) with ru(c) = α is the constant with respect to c. IN order to have Decreasing/increasing absolute risk aversion (DARA/IARA) if Ru(c) is decreasing/increasing. An example for a (DARA) utility function is u(c) = ln(c),Ru(c) = 1 / c, while u(c) = c − αc2,α > 0,ru(c) = 2α / (1 − 2αc) would represent the utility function exhibiting (IARA). Contrary to what many traders may believe having capital in your trade account does not make one adverse to risk.
Traders looking for theories on Relative Risk Aversion most commonly known as (RRA) is defined as a corresponding term with Constant Relative Risk Aversion (CRRA) and Decreasing/Increasing Relative Risk Aversion (DRRA/IRRA) look for the advantage of the value of measured risk aversion, if your apatite for risk changes and allows for higher risk tolerance, look at the coefficient for Relative Risk Aversion as c with u(c)=c1-p/1-p your risk aversion is now R/u(c)=P when P=1 this will simplify the log utility income effect on savings.
Traders may also use what is known as a portfolio theory, this allows traders an aversion to measured risk as additional margin rewards required to assume additional risk. Using the Portfolio Theory risk is measured as the mean or standard deviation of the return on investment. The Square root of the variance is measured to the n-th degree also know as the (radical) using A or An. Or A=dE(r)/dq or An.=dE(r)/dn.overUn.=1/n dE(r)/dun.
Too put this into practice terms and use, traders may limit there inherent risk exposure by utilizing good money management with appropriate risk to reward ratios, using risk capital will help limit the psychological affects of risk and risk aversion. You may also implement any risk or risk aversion formula into your trading thus limiting the risk premium; I personal use a formula of (account balance times percent of acceptable loss divided by the number of pips in my stop equals the number of lots I can trade.) simple but effective.
Adam Horak
Views: 11
Replies to This Discussion
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Permalink Reply by Jim on
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Complex article leading to a simple application in the last paragraph. A, I do wonder, though, if your personal formula is pretty risky? Assume a $5000 trading account and a 5% risk per trade. If you traded stops at 25 pips, this would allow you to trade 10 lots which seems a bit much for a $5000 account balance.
Or should I read into this that I need to start thinking of larger stops? In the above example, a 50 pip stop loss would permit 5 lots, but that still seems like a lot for a small account. Or maybe it means that my 5% loss allowance is way too high. There are so many variables. Please add your comments, A. I'm interested in managing my account mo betta.
Looking forward to more discussion on risk management.
cheers!
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Permalink Reply by Adam Horak on
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Good question... many traders as a rule of thumb use a smaller percent of maximum risk. i.e. 5% total account balance at any given time. so if you place one trade and put 5% or your account balance at risk you can’t place another trade in your account until you free up available risk tolerance. you would have to wait until that trade hits the first profit target and adjust your stop to a break even point; you would now have 5% available. I often have several trades on with smaller percentage at risk... if you have 3 trades running one at 1% one at 2% and one at 2% there is your 5% max risk tolerance... you couldn’t place another position until one of your trades reaches its first profit target, at that point you would adjust your stop to free up that available risk tolerance then you could place another trade using that available percent or less... hope this helps.
Adam
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Thanks, A. That makes much more conservative sense now. So you never have more than 5% of your trading account at risk at any given time? Whether one trade or five, the total money between purchase and stop loss is 5% of the portfolio? If you lose money on a trade, the money at risk on the next trade is less since you are using 5% of the new, lower balance. Correct?
I see this will make your account grow slower if I'm right but last longer if I'm wrong. Good advice - thx.
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youve got it...
Jim said:Thanks, A. That makes much more conservative sense now. So you never have more than 5% of your trading account at risk at any given time? Whether one trade or five, the total money between purchase and stop loss is 5% of the portfolio? If you lose money on a trade, the money at risk on the next trade is less since you are using 5% of the new, lower balance. Correct?
I see this will make your account grow slower if I'm right but last longer if I'm wrong. Good advice - thx.
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