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A study on Risk and Reward (Risk Management)

Comments, critical feedback, praise, or suggestions for new features.

Postby Djobydjoba » Thu May 21, 2020 12:27 am

Hello,

Here is a study / some thinking about Risk and Reward management, and some ideas for implementing it in Fund Manager. I have personal needs for such a management. It is not suited for all investing strategies though. I've seen that another portfolio management software had implemented in a basic way that feature, so that gave me confidence to develop ideas about it. Ideas that will be exposed here look quite logical to me, but I don't pretend this is the definitive way to go, neither all the ideas are good or accurate (I'm quite sure all are not). Do whatever you want with all of that, for me it was at least an interesting exercise to work on. :)
Djobydjoba
 
Posts: 595
Joined: Tue Mar 09, 2010 9:39 am

Postby Djobydjoba » Thu May 21, 2020 12:49 am

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1 - Context of Risk and Reward Management
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Risk management is an important matter, and certainly a developpement axis in Fund Manager. Risk management depends on the investing strategy type that is pursued. There are two main investing strategy types:

- Buy and Hold strategy
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A passive investment strategy in which an investor buys securities and holds them for a long period regardless of fluctuations in the market.

An common approach is to carefully design the portfolio composition to optimize its reward and risk over mid and long term.

Risk management concerns:
* Build an all weather portfolio through diversification (decorrelation) of the investments.
* Keep the volatility low, as the volatility is seen as Risk.
* Smooth effects of market fluctuations with Dollar-Cost Averaging strategy

Tools can be used in order to optimize the reward and risk at the portfolio level: Value at Risk, Efficient Frontier, etc.


- Market Timing strategy
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An active investment or trading strategy. It is the act of moving in and out of a financial market or switching between asset classes based on predictive methods to gauge how the market is going to move. Predictive methods can be technical analysis, economic data, or anything else (insider, crystal ball...).

In this strategy, the investments (or trades) may be opened and closed pragmatically based on the emergence of opportunities or risks. Diversification and volatility at the portfolio level may not be a significant concern. The investor/trader may focus on opportunity and risk at the investment/trade level, while controlling the cumulative risk of all the concurrent investments/trades in order to not exceed a determined threshold.

Risk management concerns:
* Control the risk of loss and the expected reward of an investment/trade
* Control the cumulative risk of loss and cumulative expected reward of total investments/trades

In order to define the risk of loss of an investment/trade, the investor/trader can use a Stop Loss (SL) level. This is the maximum loss he is willing to tolerate. In case the SL is reached, he will close the investment.

In order to define the expected reward of an investment/trade, the investor/trader can use a Take Profit (TP) level. This is the expected reward. The investor/trader plans to close the investment/trade when this level will be reached.

Stop loss and target profit levels are best defined with the help of technical analysis. But other methodologies can be used to set these levels.

-----------------------------

Of course, there are many intermediate strategies and a wide array of variations between these two main strategy types.

As an active investor and trader, I'm on the side of the market timing strategy, and I use SL and TP levels for my investments/trades. So I will focus now on how a risk and reward management with SL and TP levels can be useful and can be implemented.
Djobydjoba
 
Posts: 595
Joined: Tue Mar 09, 2010 9:39 am

Postby Djobydjoba » Thu May 21, 2020 1:09 am

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2 - Basics of Risk and Reward Management
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In order to define the Risk of an investment, a Stop Loss (SL) has to be define. This is the lowest share price the investor is willing to tolerate. In case the SL is reached, the investor will close the investment.

The Risk of the investment is: OOP Current Basis - (Shares x SL Price)

Notes:
- OOP Current Basis is the Purchase Value in FM terminology
- (Shares x SL Price) will be named SL Value
- When SL Price is "at break-even" (that is above the Purchase Price), OOP Current Basis < SL Value. In this case, Risk is zero.
- As an alternative, Risk can be calculated at market value. Risk at Market Value = Value - SL Value
- Risk can be expressed as a percentage (of Investment OOP Current Basis, of Investment Market Value, of Portfolio OOP Current Basis, or of Portfolio Market Value)


In order to define the Reward of an investment, a Take Profit (TP) has to be define. This is the higher share price the investor expects. If the TP is reached, the investor will close the investment.

The Reward of the investment is: (Shares x TP Price) - OOP Current Basis

Notes:
- (Shares x TP Price) will be named TP Value
- When TP Price is below the Purchase Price, TP Value < OOP Current Basis. In this case, Reward is zero.
- As an alternative, Reward can be calculated at market value. Reward at Market Value = TP Value - Value
- Reward can be expressed as a percentage (of Investment OOP Current Basis, of Investment Market Value, of Portfolio OOP Current Basis, or of Portfolio Market Value)


SL and TP are share price levels that the investor can change at any time along the lifetime of the investment. Risk and reward may have to be increased or decreased as changes occur in price, risk perception, expectations, technical analysis, etc.

As the SL and TP are set for each investment in the portfolio, the investor can now monitor and thus manage risk and reward, at the investment level AND globally at the portfolio level.
The investor can now identify the investments with the biggest risks and biggest rewards, and can adjust if necessary, as prices and values evolve, their values and weights in the portfolio, as well as their SL and TP levels.


Once the SL and TP have been set, the Risk/Reward ratio can be calculated. It measures the expected gains (reward) of a given investment (or portfolio) against the risk of loss. The Risk/Reward ratio is a key notion of money management, and is often used as a measure when trading individual stocks or ETFs.

Risk/Reward ratio is typically expressed as a figure for the assessed risk separated by a colon from the figure for the prospective reward. E.g. if you have a Risk/Reward ratio of 1:4, it means you’re risking $1 to potentially make $4.

In many cases, market strategists find the ideal Risk/Reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk.

Although less common and standard, some prefer to use the Reward/Risk ratio instead. It may be more intuitive to put the reward in the numerator of the ratio. In addition, the notation "1:3" may be dropped for a simple figure. Thus, the Reward/Risk represents how many $ are expected to be gained for a $1 risk. For example, a Reward/Risk of 3,2 means that you’re expecting to gain $3,2 while risking $1.

The Reward/Risk ratio with simple figure will be chosen here.
Djobydjoba
 
Posts: 595
Joined: Tue Mar 09, 2010 9:39 am

Postby Djobydjoba » Thu May 21, 2020 1:14 am

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3 - Framework for Risk and Reward management
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For each investment, the investor should be able to set the SL and TP prices by any of the following ways:
- fixed SL or TP price
- distance of Purchase price, expressed as %, or as units (e.g. 500 points)
- distance of OOP Current Basis (= Purchase Value), expressed as a risk or reward value (e.g. $500) -> the calculation of the SL or TP price is then made by the program
- distance of Market Price, expressed as %, or as units
- distance of Market Value, expressed as a risk or reward value (e.g. $500) -> the calculation of the SL or TP price is then made by the program
- % trailing of Market Price

TP Price shouldn't be inferior to SL Price. This shouldn't be allowed.

When no SL is set for an investment, there could be 2 options:
- Risk is Market Value
- Risk is a fixed % of Market Value (e.g. 20%)

When no TP is set for an investment, there could be 2 options:
- Reward is zero
- Reward is a fixed % of Market Value (e.g. 20%)


It should be possible to evaluate the risk and reward of an investment either over the entire portfolio value, or over the non-cash part of the portfolio value.

An advanced implementation could allow multiple SL and TP levels per investment, for partial orders. For example: at TP#1 sell 50% and at TP#2 sell the remaining part.

The trailing SL already exists in the Alerts feature. For SL and TP, there could be a merge between Reward-Risk and Alerts features. The Alerts features could be extended to notify when a SL or a TP is hit, to offer to make an action (close the position or move the SL or TP).
Djobydjoba
 
Posts: 595
Joined: Tue Mar 09, 2010 9:39 am

Postby Djobydjoba » Thu May 21, 2020 1:31 am

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4 - Risk and Reward fields (for reports, etc.)
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Note: Attached, an Excel simulator for Risk and Reward calculations, with examples of uses of the results. A screenshot of the simulator here.


SL Value = Shares x SL Price
(if no SL, SL Value = Market Value, or SL Value = x% Market Value, depending on the options)

TP Value = Shares x TP Price
(if no TP, TP Value = 0 or TP Value, = x% Market Value, depending on the options)


Risk at Purchase Value: OOP Current Basis - SL Value
(if SL Value > OOP Current Basis, Risk at Purchase Value = 0)

Risk at Market Value: Market Value - SL Value
(if SL Value > Market Value, Risk at Market Value = 0)

Risk at Purchase Value (%): 100 * Risk at Purchase Value / OOP Current Basis
Risk at Market Value (%): 100 * Risk at Market Value / Market Value
Risk at Purchase Value (% Portfolio): 100 * Risk at Purchase Value / Portfolio OOP Current Basis
Risk at Market Value (% Portfolio): 100 * Risk at Market Value / Portfolio Market Value
Risk at Purchase Value (% Portfolio w/o cash): 100 * Risk at Purchase Value / Portfolio w/o cash OOP Current Basis
Risk at Market Value (% Portfolio w/o cash): 100 * Risk at Market Value / Portfolio w/o cash Market Value


Reward at Purchase Value: TP Value - OOP Current Basis
(if TP Value < OOP Current Basis, Reward at Purchase Value = 0)

Reward at Market Value: TP Value - Market Value
(if TP Value < Market Value, Reward at Market Value = 0)

Reward at Purchase Value (%): 100 * Reward at Purchase Value / OOP Current Basis
Reward at Market Value (%): 100 * Reward at Market Value / Market Value
Reward at Purchase Value (% Portfolio): 100* Reward at Purchase Value / Portfolio OOP Current Basis
Reward at Market Value (% Portfolio): 100* Reward at Market Value / Portfolio Market Value
Reward at Purchase Value (% Portfolio w/o cash): 100* Reward at Purchase Value / Portfolio w/o cash OOP Current Basis
Reward at Market Value (% Portfolio w/o cash): 100* Reward at Market Value / Portfolio w/o cash Market Value


Reward/Risk at Purchase Value: Reward at Purchase Value / Risk at Purchase Value
Reward/Risk at Market Value: Reward at Market Value / Risk at Market Value
Attachments
Risk Reward Simulator.xlsx
(15.73 KiB) Downloaded 1 time
Djobydjoba
 
Posts: 595
Joined: Tue Mar 09, 2010 9:39 am

Postby Djobydjoba » Thu May 21, 2020 1:37 am

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5 - Position Sizing
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Position Sizing is a logical continuation of the Risk and Reward management features, and could be added as a new feature in the Buy/Sell Transaction dialog.

Investor uses position sizing to help determine how many units of security he can purchase, which helps him to control risk.

1) Firstly, the investor defines how much risk he want to take on the transaction, as a percentage of the portfolio value. For example, he may decide to risk 2% of the portfolio value on the transaction
2) Secondly, the investor sets a Stop Loss price
3) Thirdly, the investor indicates the price at which he'll buy one share.

-> Now the program can calculate how many shares the investor has to buy in order to match the desired level of risk.


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Conclusion
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Proper management of Risk and Reward with SL and TP are essential for traders and active investors in order to succeed. I hope that I have been able to convince of the worth of an implementation for this management.
Djobydjoba
 
Posts: 595
Joined: Tue Mar 09, 2010 9:39 am


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