Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

BENEFITS OF VALUE AT RISK

Although VaR provides traders and risk managers with a multitude of benefits, its most touted benefit—the introduction of probability of loss for a given portfolio over a specified future time horizon—is applicable to all market participants. The key feature here is VaR's incorporation of historical volatility and correlations for a specific portfolio to forecast future price risk with some notion of likelihood over a given holding period.

Risk managers and system developers utilizing traditional measures such as stop-loss and volumetric price risk analysis can tell us many essential aspects of portfolio risk, such as the likelihood of an account trading specific assets with a particular methodology experiencing a 20 percent peak-to-valley drawdown over the course of the past 10 years. Moreover, they can determine how many times such an account would have endured daily losses in excess of a particular monetary threshold (e.g., $10 million). In fact, this ability to determine the number of times that a portfolio experienced a daily loss in excess of $10 million is a nonstatistically based VaR methodology known as historical VaR.

Historical VaR allows us to establish some notion of probability in regard to losses over a given historical time horizon (such as one year) simply by counting off the worst occurrences of the trading account until we have identified the desired percentage of largest losing trading days. For example, if last year contained 255 trading ...