How to Calculate the Risk in Your Day Trading Returns
Most day traders are pretty good at keeping track of the money they have made, but generally not so good at assessing the risk inherent in those returns. Here are a couple of measures you can look at to determine the level of risk you are taking to get those trading profits.
Day traders often calculate their batting average, although they may call it their win-loss percentage or win ratio. It’s the same: the number of successful trades to the total number of trades. Not all trades have to work out for you to make money, but the more often the trades work for you, the better your overall performance is likely to be.
If you have both good performance and a high batting average, then your strategy may have less risk than one that relies on just a handful of home run trades amidst a bunch of strikeouts.
Want something harder than your batting average? Turn to standard deviation, which is tricky to calculate without a spreadsheet but forms the core of many risk measures out there.
The standard deviation calculation starts with the average return over a given time period. This is the expected return, the return that, on average, you get if you stick with your trading strategy. But any given week, month, or year, the return may be very different from what you expect.
The more likely you are to get what you expect, the less risk you take. Insured bank savings accounts pay a low interest rate, but the rate is guaranteed. Day trading offers the potential for much higher returns but also the possibility that you could lose everything any one month — especially if you can’t stick to your trading discipline.
You calculate standard deviation through a series of steps:
In Step One, you take every return over the time period and then find the average. A simple mean will do. Here, there are 12 months, so add all 12 returns and then divide by 12.
In Step Two, you take each of the 12 returns and then subtract the average from it. This calcualtion shows how much any one return differs from the average, to give you a sense of how much the returns can go back and forth.
In Step Three, you take each of those differences and then square them (multiply them by themselves) to get rid of the negative numbers. When you add those up, you get a number known in statistics as the sum of the squares. Now you have enough for Step Four.
In Step Four, you take the average of the sum of the squares.
For Step Five, you calculate the square root of the average of the sum of the squares. That square root from Step Five is the standard deviation, the magic number you’re looking for.
Of course, you don’t have to do all of this math. Almost all trading software calculates standard deviation automatically, but at least you now know where the calculation comes from.
The higher the standard deviation, the riskier the strategy. This number can help you determine how comfortable you are with different trading techniques you may be backtesting, as well as whether you want to stick with your current strategy.
In academic terms, risk is the likelihood of getting any return other than the return you expect. To most people there’s no risk in getting more than you expect; the problem is in getting less than you were counting on. This is a key limitation of risk evaluation. Of course, a few periods of better-than-expected returns are often followed by a run of worse-than-expected returns.