Risk is a two way street, it describes the amount of money an investor is willing to lose to achieve their gain. In theory, the more you are willing to risk, the more you have to potentially gain on any specific trade. Risk is a function of your desired reward, but your risk is not what you actually lose but what you are willing to lose. There are a number of ways to calculate risk. You can make it simple by terminating your exposure after you lose a specific percentage of the funds invested. You can pick out point on a chart and determine the maximum you might lose if a price a security moves to that location. A popular tool that is used is VAR “value at risk”. This methodology describes the amount of capital may can be gained or lost given a change in the securities in your portfolio.
The calculation that comprise value at risk or as it is also known “VAR” have been around for a long time but the metric was not widely used until the Securities and Exchange Commission (SEC) mandated some form of calculation following the 1987 stock market crash. The concern was that banks that trade could default if there was not a measurement that calculated how much they were risking given a large outsized move in the financial markets. The SEC installed liquidity requirements in an effort to provide sufficient liquidity to institutions so that they have enough capital to withstand a 2-standard deviation move. Historical performance where the first data points used to calculate var.
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