The 3 Musketeers of Risk AnalysisIntroduction:
In the world of investing, managing risk is as crucial as seeking returns. Three vital tools for assessing risk-adjusted returns are the Sharpe Ratio, Sortino Ratio, and Omega Ratio. In this post, we'll explore these ratios, their calculation, their unique features, and when to use them.
1. Sharpe Ratio: Balancing Risk and Return
Measures risk-adjusted returns using total volatility (both up and down).
Formula: (Return - Risk-Free Rate) / Portfolio Standard Deviation.
Strength: Widely accepted and provides a simple assessment of risk-adjusted return.
Weakness: Assumes normal distribution and ignores skewness.
2. Sortino Ratio: Focusing on Downside Risk
Emphasizes downside risk.
Formula: (Return - Risk-Free Rate) / Downside Deviation (only negative returns).
Strength: Ideal for risk-averse investors and non-normally distributed returns.
Weakness: Ignores upside volatility.
3. Omega Ratio: Probability of Positive Returns
Evaluates risk-adjusted returns based on the probability of achieving positive returns.
Formula: Probability of Positive Returns / Probability of Negative Returns.
Strength: Provides insights into return probabilities and considers tail events.
Weakness: Less recognized and may require more data.
Conclusion:
Understanding these ratios helps investors make informed decisions. The Sharpe Ratio simplifies risk-return assessment, the Sortino Ratio prioritizes downside protection, and the Omega Ratio analyzes return probabilities. Combining these ratios offers a comprehensive view of investment performance in an unpredictable financial world.
Riskanalysis
RISKOMETER Based on Your Trading Style ⚠️
Hey traders,
In this educational post, we will discuss the relation of risk to your trading style.
1️⃣ High Frequency Trading (HFT)
It is a complex algorithmic approach that is used to operate on second(s) time frames.
Such a style is considered to be the riskiest one.
With a very high frequency of order execution and sophisticated strategies, it requires a very high level of experience and proper software and hardware for successful operations.
2️⃣ Scalping
It is a manual trading style with operations on minutes time frames.
With the average holding period ranging from minutes to hours, scalping requires a high degree of attention and constant charts monitoring.
Being one of the most profitable trading styles for retail traders, scalping involves an extremely high risk and mental load.
3️⃣ Day trading
The form of speculation in which the traders attempt to make profits within a single trading day.
Occasionally, however, day traders may hold their positions overnight.
Day trading is considered to be slower than scalping, with the trade execution on hourly time frames.
Slower pace drastically reduces risks also limiting the potential gains.
4️⃣ Swing trading
It is a style of trading that is aimed to make profits on swing moves, with an average holding period ranging from days to weeks.
4H time frame is the lowest time frame where swing traders usually operate, and a daily time frame is usually the highest one.
The operations on higher time frame dramatically reduces the noise and degree of manipulations, making that style of trading relatively safe.
5️⃣Investing (Position Trading)
Trading / investing style aiming to make long-term profits.
The average holding time of a position trader may expand to years.
In comparison to other trading styles, investing generally produces the smallest gain. That is, however, compensated by extremely low risks.
Correct understanding of relations between trading styles and potential risks is crucially important for a selection of an appropriate style for you.
Shorter is the holding period and operational time frames, higher is the risk, but higher are the potential gains.
You should pick the style that fits your risk-tolerance and expectation.
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Position & Swing Trading: Weekly ChartsIf you're position or swing trading, it is a MUST to study weekly charts to confirm:
1. IF a bottom is developing
2. WHERE the bottom will complete
...to plan trades with strong reward/risk ratios.
For example, let's take a look at EGLX, which had a gap up at open on its earnings release:
1. Note that today's gap up is from a lower low in the downtrend. This particular bottom is not confirmed just yet. When it makes a higher low is when there will be lower risk for an entry.
2. The first resistance is at 3.27, but there's stronger resistance at 4.44--once the stock's price sustains that level, then the bottom will be complete, which is the best time to consider position trade entries.
Both resistance levels should be considered for swing trading potential...
First ask: "Are there enough points to gain from your entry point to warrant the risk of the trade?" If no, then move on to the next opportunity; maybe put an alert at the next resistance level to revisit. If yes, then which resistance levels are likely to cause profit-taking?
A step-by-step checklist that looks further than the entry is important for not giving back profits just as soon as you make them. Learn more at my website.
Technical Analysis for Risk AnalysisTechnical Analysis should be used for Risk Analysis, not just for deciding if and when to buy whatever it is you want to trade, whether it's stocks, crypto, forex, indexes, ETFs, REITs, mutual funds, etc.
When you know the technical patterns that point to higher risk, aka sellers gaining traction, you can get out of long positions before the retail crowd and its small fund managers react late to earnings reports.
It is NEVER the largest institutions, who we call the Dark Pools, who are selling on earnings announcements. It is ALWAYS the less informed who buy or sell on big news days.
This is what we at TechniTrader call "Relational Technical Analysis"--the application of what we know about the market participant groups to discern who is doing what in the technical patterns of a chart.
For example: UPST was a struggling IPO anyway. The typical IPO top and drop occurred in October-November. 99% of new IPOs do this. Learn to sell at the peak of a speculative new IPO. That means you must learn what speculation looks like in the charts and how to recognize the top developing so you can get out before the drop.
But today's lesson is about the specific set of negative technical patterns developing ahead of Upstart's earnings report yesterday after the market close:
1. A trading range was developing lower highs and lower lows.
2. Compression of price at the low end of the range.
3. Declining Accumulation/Distribution over the sideways action of the trading range.
These are what we at TechniTrader call the "footprints" of controlled rotation out of the stock ahead of the earnings press release date.
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