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.The definition of trade risk is: The possibility of financial loss from anindividual market position. The definition of strategy risk is: The possibility of financial loss fromthe use of a trading strategy. The definition of portfolio risk is: The possibility of financial loss atthe portfolio level (potentially multistrategy, multiple time frame and mul-timarket) from the sum total of all trading therein. Let us examine each of these forms of risk in more detail. c05 JWPR070-Pardo December 14, 2007 13:59 Char Count=80 THE EVALUATION AND OPTIMIZATION OF TRADING STRATEGIESTrade RiskDefinition: A trade risk rule seeks to limit the amount of trading capitalthat can be lost on each individual market position.The definition says seeks to limit risk because there are circum-stances that can cause losses to exceed that amount initially set.Theseare explored in this section.The primary way that risk is managed at the trade level is through theplacement of a stop-loss order the risk stop which will automaticallyliquidate the trading position if exceeded.For this method to be effective,the stop order must be placed when the position is initiated.Risk at position entry and beyond can be limited to the approximatevalue of a specific dollar amount by using a risk stop set at a price levelequal to the desired risk.Definition: A risk stop limits the amount of capital placed at risk attrade inception and through the life of the position.It is a stop order thatis entered at inception and is maintained through the life of the position.Ifthe price of the risk stop is touched or exceeded, the position is uncondi-tionally liquidated.The calculation of the size of the capital to risk can be done in a myr-iad of ways.Three representative examples are presented.But first, it isessential to understand how and why these risk amounts can be exceeded.On the whole, risk stops perform their intended function and keep trad-ing losses near their anticipated level.Market conditions can and will oc-cur, however, that will cause actual trading losses from these stop ordersto exceed the desired level of risk.For example, risk can be exceeded because of fast markets and theconsequent poor order executions.What is essential to note is that orderexecutions at price levels worse than the price of the risk stop are a fact oftrading life.This is the main reason that an accurate measure of slippagemust be factored in to trade cost in the historical simulation process.Thisis addressed in detail in Chapter 6: The Historical Simulation.The definition of slippage is The transaction expense charged by poorquality executions. It is the difference between the order price and theactual execution or fill price.The other main reason that levels of risk set by the risk stop are ex-ceeded is overnight risk.Definition: Overnight risk is the amount of capital that can be lost byadverse changes in price between today s close and tomorrow s open.Whereas the gaps between close and the following open are not in-finite, they occasionally can be very large.Let us examine the impactthat these sometimes large adverse close-to-open gaps can have on a riskstop. c05 JWPR070-Pardo December 14, 2007 13:59 Char Count=The Elements of Strategy Design 81Consider that a risk stop employed to limit position risk must be placedas a Good Till Canceled (GTC) order.To limit risk, a risk stop must be keptin place from the beginning (entry) to the end (exit) of a position.However,this does not limit the trade risk to that set by the stop price.This is becausethe overnight close-to-open change can and will be larger than that set bytheriskstop.For example, if the market s opening price exceeds the 2.00 point riskstop by 10.00 points, this order becomes a market order on the open andwill be filled in the opening range and will incur a loss 8.00 points greaterthan that set by our risk stop.Overnight risk is a potentially more dangerous form of trade risk.Theonly sure way to entirely eliminate this risk is to close out the position ev-ery night.That, however, is not always a desirable feature in a trading strat-egy.Understanding overnight risk, however, provides the strategist with anopportunity to more specifically manage this particular form of risk.Let us now consider three examples of ways to define the amount tobe risked during a trade and is managed by the risk stop.The most common way to set a risk stop is to use a dollar amount thatthe trading strategist is willing to risk each trade.Definition: A dollar risk stop is an unconditional exit, at a loss, at apoint equal to a dollar amount above or below the entry price.For example, assume a risk stop set at $1,000 (assume $1,000 is equalto 4.00 points) and a long position is entered at 350.The sell risk stop toexit this long position then is 346 (350.00 4.00 = 346.00).The sell stop isplaced at the time a long position is taken, based on the strategy entry rule.If price subsequently goes against the new position and exceeds (falls toor below) this risk stop, the trading system exits the position with a $1,000loss plus commissions and any slippage that may occur.A buy risk stop fora short position is calculated opposite to that of a long position.There are myriad ways to arrive at this dollar amount.The very worstway to set this amount is to base it upon a value arrived at simply by thewhim of the strategist.The positive aspect to this form of risk stop is thatit is likely to be emotionally comfortable to the trader.The reason why thismay be a bad idea is that this method of setting risk is most likely to haveabsolutely nothing to do with that risk level, which will actually minimizerisk while maximizing profit.The best way to set this risk amount is to base it on a manner that iscongruent and in harmony with the rhythm and operation of the tradingstrategy.Let us consider another rather typical and generally better way to de-fine trade risk.Definition: A volatility risk stop sets trade risk using some measure ofmarket volatility. c05 JWPR070-Pardo December 14, 2007 13:59 Char Count=82 THE EVALUATION AND OPTIMIZATION OF TRADING STRATEGIESThere are many ways to calculate volatility, of course.Let us considera relatively simple example.The main reason a volatility-based measureof risk is superior to a fixed dollar value is that it will adjust as volatilityexpands and contracts.Let us use the daily range (high minus low) as our basic unit of volatil-ity.Let us further assume that we will use a three-day average of dailyranges as our measure of risk.Finally, let us assume that this three-dayaverage volatility on the first day of entry is 5.55 points.Then, a sell riskstop for our long position of 350 set at 5.55 points will be 344.45 (350.00 5.55 = 344.45).Buy risk stops for short positions are calculated the oppo-site way.Our last example of risk calculation is based on a percentage of tradingequity.It is included as an illustration of an oft-cited method of risk calcula-tion.The famous trader and pioneering technical analyst W.D.Gann madefamous his Rule of Ten in which he said, Never risk more than ten percentof your trading capital on any trade
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