The importance of risk management to portfolio performance cannot be overstated. There are a dazzlingly wide range of metrics to measure risk and related concepts, enough to fill many volumes, but in this article we will review just the most important ones for your forex portfolio: Standard deviation, value at risk and volatility.
These three metrics provide a useful introduction to the world of forex risk management. A better understanding of risk is one of the most important steps you can take as a budding trader towards more consistent and stronger performance.
What is risk?
In a financial markets context, risk means the likelihood of a sudden loss of value of your portfolio. This is often referred to as ‘market risk’. Risk is different from volatility, which is the level of price fluctuation in a market.
One way of thinking about securities markets is that they are systems to pay people for taking on the risks of others, in a less formal but quite similar way to an insurance contract. Riskier assets and currencies typically pay more (or have higher yields), than safer ones.
Other types of risk exist, such as credit risk, the risk of a company or country defaulting on its debts, but usually in the context of forex risk management risk nearly always refers to market risk; in other words, to negative price volatility.
How does risk influence returns?
If you buy the debt of a company, you are taking a risk that they will go bankrupt and be unable to pay. You expect a certain rate of return in exchange for taking this risk, and this rate will be higher the more risky the company is. With corporate and government debt, credit rating agencies provide a scale to identify the likelihood of a default; for currencies, you have to do any relevant due diligence yourself.
In the same way that a bond trader is exposed to both market risk and the credit risk of the issuer, when you buy the currency of a particular country you are not just exposed to price volatility but to all the risks of that economy and its central bank: Inflation, indebtedness, the competitiveness of their industry. For this to be worthwhile, the most volatile forex pairs are expected to have higher returns. You would quite naturally expect to make more from a long Turkish Lira trade than a long US Dollar trade.
Do all trades come with risk? Basically, yes: A ‘risk-free’ asset exists, at least in theory; US Government debt (called ‘treasuries’). The likelihood of the US government defaulting on its debts is considered so low as to be effectively zero, so the yield of US government bonds is used as a ‘risk-free rate’ in financial calculations. A handful of countries, notably Japan and Germany, have seen their debt trading at a negative yield, meaning the risk level is so low you actually need to pay for it. With these notable exceptions, all financial instruments include a certain level of risk.
How do we measure risk?
There are multiple measures of risk used in forex risk management. Three of the most popular are standard deviation, volatility, and value at risk. This list is by no means exhaustive, but the three metrics give you a range of different ways to calculate and identify risks to your currency portfolio.
Standard deviation is a key concept in statistics and measures how much the members of a group of numbers differ from the mean of the group. You will often see the Greek letter sigma (σ), or the letters SD used as a shorthand for standard deviation.
Standard deviation can be used as a simple measure of forex volatility, where the higher it is the higher the volatility of a particular pair. The distance of a value from the group mean can also be expressed in units of standard deviation – this is relevant if you are comparing a short sample of price history with a longer one.
In forex, keeping an eye on the standard deviation helps to give an idea of overall market volatility. The lower the SD value the less volatile the currency pair is. An increase in standard deviation could be a sign that the market is becoming less stable, and further large price moves are on the way. As with volatility, standard deviation does not differentiate between downwards price moves and upwards – an asset which increases in price rapidly day after day for a month would have a very high monthly standard deviation.
Volatility measures the size and range of price moves in a currency pair. A more volatile pair is one which sees larger and more sudden moves, and a currency pair with low volatility will typically have a stable price. Volatility refers to both positive and negative price moves – an asset showing a long run of dramatic price increases will show high volatility.
The most volatile currency pairs are normally emerging markets currencies, such as USD / ZAR (South African Rand), which showed an average monthly volatility of over 12% in 2021. This is far higher than the typical monthly volatility of major currency pairs, where even the most volatile such as USD / JPY range between 3 and 5%.
Forex traders often like to trade more volatile pairs, as it is difficult to find major returns (without significant leverage) in small price moves. Nevertheless, remember to use a stop loss and other risk management tools when dealing with any volatile currencies.
Value at risk
Though volatility is a vital financial metric, one of its main limitations is the inability to distinguish between positive and negative price moves. Value at risk (VaR) is a more sophisticated measure that aims to measure solely the risk of loss in an investment.
Value at risk readings are quoted for a time period, as a sum and as a percentage, normally 95%, as in $1,000,000, two weeks, 95%. This means the maximum expected loss over a two week period is $1 million, within a confidence limit of 95%. In theory, there is a 95% chance that any losses would be lower than the VaR.
VaR is calculated using an estimate of volatility in the market and the correlation of different assets. Both the 95% and more stringent 99% confidence levels are used by major financial institutions around the world as a risk management tool.
VaR has faced considerable criticism within the financial industry, with American hedge fund investor David Einhorn calling it ‘an air-bag which always works, until you have a car accident’. Their criticism rests on the idea that VaR provides an illusion of safety to traders, but since correlations and volatility often suddenly appear during market stress, it fails to accurately capture market risk.
How to use these measures
As a retail investor in the forex market, it is vitally important to be aware of the different measures of risk used in the industry. Different metrics are appropriate for different situations, and there is no magic bullet that allows you to identify risks 100% of the time. A few useful reminders:
- Volatility refers to the variability of a price over time. The higher it is, the greater the swings in price, either up or down.
- Standard deviation measures how spread out a group of numbers are from their mean. In trading, the mean is usually a moving average, so this is effectively an alternative measure to volatility, with the same advantages and disadvantages.
- Value at risk (VaR) is a more complex alternative used in the financial industry to specifically measure the risk of losses. It is quoted for a time period and with a confidence limit. It’s use is controversial and some argue it is not an effective tool for traders.
Successful risk management
Whether you trade using fundamental or technical analysis risk management is going to be a vital part of your overall strategy. By knowing more about the various metrics available to you as a trader, you can make more informed decisions about how to monitor and trade your portfolio.
How Rakuten can help
If you are keen to put some of your new risk management knowledge into practice, why not sign up for a free demo account today and start placing trades today without risking any of your capital?