It All Starts With Having A Risk Budget For Your Investments
Failure to plan is a plan to fail. Risk budget is a commonly used tool for institutional investors when they do their asset allocation and portfolio construction. However, it is probably the most neglected concept among retail investors. It dictates how much risk to take on and how much returns to expect accordingly. Investments are all about risk and returns. The same can be said for trading.
Below are a few simple steps which you can follow to derive your own risk budget
– What are your expected returns on a daily/monthly/yearly basis, whether it is in dollar amount or percentage.
– How much risk you are willing to take to generate these returns. Risk are measured in term of volatilities (deviation from the means). However, for the purpose of trading and simplicity we can use proxy instead of using spreadsheet to calculate precise historical volatilities of any underlying assets.
– The dollar amount required to achieve the expected returns given the predetermined level of risk.
For example, if you would like to generate $1000 profit a day with a capital of $250000, the expected daily returns would be 0.4%. If you are trading $250000 per ticket, the daily movement of the chosen currency is expected to be at least 0.4%. Of course, out of the $250000 capital, your equity could be much less with the use of leverage. Usually FX are traded on an initial margin basis, however you do need much more than the initial margin to implement good risk management techniques.
Now we know that we need a minimum of 0.4% movement on a daily basis (let’s call it volatilities here for the purpose of discussion in this section although the real volatilities are calculated differently academically speaking). This would serve as a guide when we decide what currency pair to trade. If we choose a currency pair which has a lower volatilities, we would need to increase our capital / ticket size in order to achieve the expected returns. If we choose a currency pair which is more volatile, then a smaller ticket size would suffice. The currency pair we choose to trade would determine our implied level of volatilities or risk.
In short, the higher the expected risk the higher the expected returns would be. Risk can be controlled in two ways:
- Volatility Of The Currency Pair
You can add on risk by choose a currency pair with higher volatilities and take away risk by trading a currency with lower volatilities.
- Level Of Leverage In The Capital Structure
For the same currency pair you decide to trade, you can add on risk by having less equity and more debt (leverage) in your portfolio. When you put in more equity and reduce debt (leverage) in your portfolio you also reduce the level of risk.
Some people prefer lower underlying volatilities (of a currency pair) and enhanced with more leverage in the capital structure. Others would prefer more volatile currency with less leverage in the capital structure. It is this preference which would predetermine the currency pair to trade and focus in.