The Four Faces of Risk: Defining and Managing Risk in Trading System Development and Trading Management
Risk is the primary limitation to trading profits. In the development of trading systems and management of trading, risk appears in four situations:
- Personal risk tolerance. Each trader — person or trading company — has a risk tolerance. It is the amount of drawdown in the trading account where the trader loses confidence in the system and takes it off line.
- Risk inherent in the price series. Each primary data series — the price series of the issue being traded — has risk inherent in it. That risk can be measured and used to determine the suitability of an issue for trading
- Risk of a trading system. The trading system — the model (the combination of indicators, parameters, and rules) together with the data — has both risk and profit potential. Risk of the system can be measured, maximum position size determined, and profit potential estimated.
- Risk management as conditions change. As trading conditions change, risk changes. Risk can be assessed trade-by-trade, enabling the trader to determine the current maximum safe position size, and to compare alternative trading opportunities.