System Trading - Part 4a: What is risk

Of all the facets of System Trading Risk Management is the most critical aspect. This makes or breaks the overall system results. In this part I just want to share my definition of risk in investment.

What is risk?

In classical theory volatility is taken as a yardstick for measuring risk. But let's take a step back and try to define it.

When do we say an investment is risky? If we know we might not get our principal back. Should that be the baseline? Maybe not because if I had kept that money in a government bond I would have got 6% annualized. So now my minimum base line is that the money I put in an investment should give me

• my principal back with 100% probability and 
• an interest earning of 6% on the principal with 100% probability 

Can it give lower returns? No! I want this total return, as a GOI bondholder I am assured of this 6% unless the country defaults. Ok what is the probability of India defaulting? It is certainly not zero.

So my overall function of risk becomes a function of the probabilities of getting my principal back combined with the probability of getting interest on that principal.

Note when I have 100% probability of getting my principal back and interest is assured again with 100% probability then I can say it is a riskless investment. But ideally the probabilities should be matched to the benchmark in this case GOI bond. 

But what if the probability of return of principal falls to zero? It is a pure wipeout. In option trading we use this term called 'sudden death' (I guess in football too).

Now what has these probabilities of Principal plus Return Rates (in the above example interest rate) got to do with volatility. When we go from one day to another or any other timeperiod of choice these probabilities change and thus our overall measurement of risk should change for that investment. 

Let us break into two components. Now tomorrow the probability of default on principal and return rate actually falls does our risk change? Yes it does, it becomes less risky. But there is no benefit to calling it risk if it moves in our favour. That is rather opportunity isn't it. So ideally upside move should not affect our notion of risk associated with our investment.

But when the probability of losing a part of principal rises meaning we might get lower than what we had put in or what we had calculated as an outcome from that investment then certainly the position has become more risky. It is then our risk management systems should kick in. Is it so?

What about when an investment loses its riskiness tomorrow and then increases in riskiness day after tomorrow. Should not we have done something tomorrow for risk management? Yes we should have.

For a single position portfolio when the probability of expected return reduces that is the position becomes riskier we need to have a cut off mechanism to conserve capital. And when the position becomes less risky meaning the probability of expected returns increases we must have a mechanism to conserve that additional notional profit.

The above paragraph is the core idea behind stop loss/trailing stop loss and profit booking. A system needs to have a stop loss and a profit booking mechanism. Without these two it is more akin to a gamble on the roulette wheel where the edge is in favour of the house!

In the next part of system trading I will illustrate one example of conserving capital and booking profits. As a typical boring disclaimer it will be for educational purposes only.