Thursday, September 05, 2013

Risk and volatility

Some people confuse risk and volatility in trading. A high level of volatility does not automatically mean a high level of risk.

As a trend follower, the general premise is that you cut losses short and let profits run. We limit the potential downside on any position, but have no limits on the upside. Therefore, we strictly control risk. However, as we do not work towards profit targets, all the volatility is restricted to the profitable side of a trade.

As famed trend follower John W Henry stated: "Giving back a profit to you probably seems like risk, to us it seems like volatility".

This is why trend followers generally cut losing positions quickly, yet their exit parameters allow profitable trades space to oscillate, but not invalidate, the trend they seek to profit from. In other words, we seek to embrace (and profit from) upside volatility, yet we do not entertain volatility on the downside.

As I have mentioned in some recent posts, this is one of the reasons I do not keep a close eye on open equity (overall equity balance including open positions). My greater concern surrounds cash equity. I do not tolerate being stuck in loss making positions. My own cutting of these trades (quicker than most trend following systems) means that this is a far more relevant and conservative metric to keep an eye on, and base my position sizing around.

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