Unfortunately there are many investors out there who do not appreciate risk management as a crucial part of active investing. I still often have to count myself in with those people. To succeed in trading it is necessary to pay attention to risk management as much as you do to your entry strategy. I find that value at risk (later abbreviated as VaR) may be one of the very best risk management tools there is by which can calculate your potential loss over a given period at a given confidence interval. This computation tells whether a strategy can survive or not.
How to calculate VaR
To calculate VaR we have to assume the returns of the strategy are normally distributed.
The returns should be logarithmic returns since we are calculating different instrument´s returns and that are not linked to each other.
First we need to give the function a confidence level. Usually traders are interested in the bottom 1% of the left hand side of the return distribution. Hence with a 1% probability what is the biggest loss over the given time period?Therefore the confidence level is 99%. Then we need to calculate the standard deviation (STDEV.S) and mean (AVERAGE) return of the strategy. My strategy gave me the numbers 0,188 and 0,045. After that we multiply the portfolio value with the minimum return given by the confidence level (NOMR.INV) and we get an account value of 6072,23€ (with 10K€ starting cap). Subtracting these sums I get a VaR of 3927,76€. That means there is a 1% chance of losing 3927,76€ within one day trading. That is a heck of a lot exposure I´d say.
