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Risk Management, Technical Analysis, Trader education

Market Risk: Principles and Practice

The longer a position is exposed to different market conditions, the higher the probability of an adverse event occurring but actual losses depend on entry level. In this article I provide a simple method for estimating the risk of a passive investor or trend-follower.

Those who buy at the top of the market are the biggest losers during a correction while those who bought near the beginning of a trend may still profit. However, a loss is a loss and an equity drawdown always hurts even if it regards unrealized profits.

Measures of risk and their probabilities usually depend on time horizon. Obviously, if a prolonged correction occurs, accumulated losses will depend on time: 1-day risk will be different than 5-day risk and so on. Although this subject can get highly mathematical and many do this for their own purposes – others to impress readers and others because they are looking for the Holy Grail of Risk Management – passive investors and trend-followers should be aware of the following risk principles when trading the long side of index ETFs, like SPY for example:

Principle 1:  Theoretically you can lose everything but in practice downside is limited
Principle 2:  Investors and traders on margin can lose more than their initial account
Principle 3:  A stop-loss is not always good risk control as the market can gap below it.

Example: Estimation of 20-day risk in SPY

Below is a practical estimation of 20-day risk for passive investors and position traders in SPY but the method used applies to all markets and time periods.


The above unadjusted daily SPY chart since inception shows on the first indicator pane the 20-day percent arithmetic return. The mean 20-day return is 0.64% and the standard deviation is 4.52%.  The largest negative return was a -29.81% on October 20, 2008.

The above statistics are useful if one would like to estimate how much could be returned on the average in a 20-day horizon in SPY. However, if we would like to calculate statistics about downside risk, we must consider the negative returns only because we are simply not interested in positive returns, which apply a positive skew to the mean.

The bottom pane shows the negative returns only, 1,998 in number. The mean is -3.68% and the standard deviation is 3.61%. Therefore, on the average, a 20-day horizon during negative conditions has generated a loss of -3.62%. So what is the risk when holding SPY for 20-days?

Just go back to the principles. Principle 1 says that there is possibility to lose it all but that is unlikely. Obviously, nobody expects SPY to go to zero. But on October 20, 2008, SPY fell nearly 30% in 20-days and this has occurred, it is not a hypothesis. Then, along this current bull market that started in March of 2009, SPY dropped -10.56% in a span of 20 days in June of 2010 and -16.3% in August of 2011, although this is considered one of the most dynamic uptrends in the recent history of the market. Thus, even in a strong uptrend. this market has generated some nasty corrections in the recent past.

Therefore,  if we assume that our sample population is representative of the actual distribution of 20-day negative returns of SPY, then there is a 32% chance of a  decline greater than -7.3% and a 5% chance of a decline greate than -11%, in equity (one and two standard deviations bands). In the case of someone who entered the market in 2012, losing 10% of equity still leaves substantial profits but it can be a large blow to someone who entered the market recently driven by calls of a secular bull market by retail brokerages.

About using a stop-loss

A stop-loss is a very useful risk control tool in the case of orderly markets but in the case of disorder or black swans the market can gap below a stop-loss. If the stop-loss is in the market, then the order will be filled at the first available market price, which may be very far away from the desired stop price. Countless of traders and investors, especially in individual stocks but also in futures and forex, have been ruined by such events. On the other hand, keeping a stop-loss mental may impact discipline. A more advanced trader or investor is one that can execute a mental stop-loss with discipline. However, in the case of black swans experienced traders and investors often do not execute the stop-loss but seek to average down first to reduce losses. This works if there is a short-term recovery but if the market continuous to decline it is a catastrophic method that is recommended only to those who know gambling rules very well and have access to algorithms for their implementation. The average Joe will most often get burned really bad trying to average down, mainly due to stress and ignorance of risk.

Disclosure: no relevant positions.
Charting program: Amibroker