THE SIGNIFICANT INDICATORS OF RISK ANALYSIS

In the framework of this course we cannot research too deep the appropriate material. We will only note that the risk analysis - it is independent area of science, that is based primarily on mathematics and statistics. Due to the research in this area  it is possible to come to some conclusions about the results that may be expected from the system in future on actual basis (on basis of the information about results of transactions, i.e. of statement).

We will consider here (only with the aim of illustration) two important indicators:

• MDD (Maximal Drawdown Down)
• RF (Recovery Factor)

These two indicator in combination give us the image of system ability to return at the first level of balance after the transaction. Let us discuss it more profoundly.

Originally at the fund exchange market, where trading is led by sessions (for example, from 9 a.m. to 18 p.m. in accordance to a time zone), MIDD indicator was used (Maximal intra-day drawdown). Taking into consideration that in the end of the day all the transactions should be closed, this indicator could be interpreted as the maximal drawdown of the whole period of trading.

Look at the illustration.

Picture 18. Maximal growing drawdown

Here we can see that changes in balance was developed as follows. The stable deposit growth with relatively small drawdown took place before a-point, and this is of not our interest right now. the first significant drawdown appeared at a-point, that, however is not maximal growing drawdown, as later (after small recovery) the decrease of the balance level continued and b-point saw another local minimum. However b is not maximal drawdown. C-point saw absolute minimum of deposit of the whole history of the trading, and the distance from the "x" local minimum (blue line) is MDD indicator.

What should be reviewed with attention. Here we will not take the probability theory, however we should note that it is clear intuitively for any person. If there were several unprofitable transactions and that led to drawdown at "a"-point, then an analytic, that reviews this graphic should think of what will happened. for example, of this situation repeats. We have the second drawdown at "b"-point, that is remarkable of the fact that after the first drawdown the balance has not recovered yet. The third drawdown (at c-point) was less deep, however, it kook place until balance could recover  to "x" point.

Here we came to the point where the second indicator should be introduces - Recovery factor. It is the correlation between the absolute profit (for the whole period) and maximal increasing loss, i.e.

this indicator reflects indirectly the system ability to recover after drawdown, and consequently its stability and efficiency. Most analytics agree that 1.6. recovery factor is a ground one. Under condition that the system has demonstrated the recovery factor more than 1.6, this system can be regarded as stable and effective one. If the recovery factor is less than 1.6. the loss of deposit is more probable, as the speed of recovery after drawdown can be not fast enough.

In conclusion to this chapter it should be noted that two reviewed factors can be used for the most general analysis of the given statement of system work. Nevertheless this method is quiet simple and effective. You can find more detailed information among books in The List of Recommended Literature

SEVERAL GENERAL RULES OF MONEY MANAGEMENT

These rules of money management increase the money deposit security and provide secure work with operations with the highest possible profit. In other words they are called The rules of money management. The contemporary trading demands to stick to MM rules strictly without any guarantee of a profit though.

To provide security of money deposit it is necessary to stick to the following rules:

1. Total sum of invested money should not be higher than 50% of total fund. This rule is a foundation of the rule of estimation of margin under the opening of the position. many analytics think that the percent of invested means should be smallest than 5%-30%. It has to be noted, that we talk about the total sum (for several transactions). Thus this rules does not mean, for example, that it is reasonable to put all 50% to one transaction.

2. Total sum of money invested in one transaction should not exceed 10%-15% of total fund. In this case a trader has a guarantee that he will not become a bankrupt. In general, it means: don't put all your eggs in one basket.

3. The norm of risk for each opened position, that is defined by the stop-class level, should not exceed 5% of total sum of money. Thus if a transaction is unprofitable, a trader will be ready to lose 5% of his money. 5% is taken from Murphy works, however, for example, Elder takes 1,5 - 2%.

4. Total sum of deposits to the opened positions in one group of markets should consist of no less than 20%-25% of total capital. It is concluded from the fact that many other currencies behave the same way against dollar, especially after publication of economic news in the USA. That is why to diversify risks it is necessary to world both with currency pairs, that include dollar, and with cross-rates. Under such a condition the losses only in the opened positions will be covered partly by the profit gained from other ones.

There are certain rules that concern stop-loss and take-profit levels setting at the moment of opening the positions. All currency pairs are divided into those with high and low volatility. Most traders work with so-called "intra-day" trading, where the position are opened from 1 to 3 hours. These positions work with general "intra-day" market movement. To leave the position opened for the next day, you should have compelling reasons. The size of currency volatility defines the level of so-called "price noise", that is defined approximately as follows: 24-hours candlesticks are taken from zero-point GMT to zero-point, their size between shadows is measured (the distance between points "high" and "low"), and the given value divides by 24. The experience shows that the minimal value of price noise is approximately equal to 30 points, these currency instruments are called "of low volatility". If the minimal value of price noise is from 40 points the currency instruments are called "of high volatility". For the "intra-day" trading there is no sense to use stop-loss smaller than the price noise value, i.e. the invoiced value of stop-order cannot be smaller than 35 points.

5. The invoiced stop-loss/take-profit balance for one opened position cannot be lower than approximately 1:2; in other words, from mentioned above it is clear that invoiced stop-loss value cannot be lower than 35 points, and the take-profit value, respectively, higher than 60 points. This rule permits to have a small profit on account if the balance of successful and unsuccessful transactions is equal to 1:1.

There is a number of rules that has to be followed in trade operations. Generally speaking, a trader should be highly disciplined and organized to work in Forex, he should use certain systems in his work. Considering the intra-day trading, it is necessary to stick to the following rules:

1. It is necessary to analyze the situation at the market before opening the trade terminal in the beginning of the day. It means you should answer the questions: where are prices situated right now and why, what has happened at the moment when a trader did not track the movement of prices.

2. It is also necessary to meet with economic news calendar for a today. In what time (GMT) what news are published, and can they influence on the market and the movement of prices. The skills in the fundamental analysis are gained only with experience, thus the practical experience in trading is needed.

3. It is necessary to define current strength levels of basic currency instruments, used in trading, and current intra-day price diapason.

4. Using the results of analysis, it is necessary to make a trading plan for a day, that will include: the price limit of entering the market, the stop-loss level, the possible size of profit and, relatively, take-profit level. The conditions of entering the market and its quitting. The price situation, that will be freelance and will require immediate market quitting. It is necessary to understand that you should take into consideration the analysis conclusions in your decision making about entering the market and do not react on current losses in opened and transferred-to-the-next day-positions. It is necessary to make a strict plan of the term of the transaction while opening the positions, and after this term it is necessary to estimate the possibilities of quitting the market before significant changes in prices that can take place after movement during the night.

5. It is necessary to stick to the trading plan. You should answer the question: "What is the reason of entering the market?". The reason should be the combination of coincidence of analysis conclusions with current price situation, confirmed by technical indicators (no less than two).

6. It is forbidden to move the calculated earlier stop-less level in the direction of increase of possible losses, independently of situation. The work without stop levels is regarded to be even more risky.

7. While entering the market it is necessary to take into consideration possible currency rates moves after the publication of economic news. Short-term strong moves of currency rates may break stop-orders, and then the market will follow the direction that was defined by the trader. It is recommended to refuse to open additional positions and to save the current ones within 30 minutes before the publication of economic news that can influence on currency rates to a greater extent. You can do this by moving stop-orders to the point of no losses, or by closing the current positions taking into account the possible rate fluctuation.

The given rules can be used for the preparation to the transaction making and to the process of trading. Now we are going to discuss how you can analyze history of transactions on actual basis and what general indicators should attract special attention except of the growth of deposit or funds

GENERAL IDEA OF MONEY MANAGEMENT

Important parts of financial market trading is money and risk management. If market analysis (either technical or fundamental one) exists to give answer to the question "when and to which direction a position should be opened", money and risks management answers to the following questions:

• How to provide higher speed of money growth when risk is optimal;
• How to minimize risk when money growth speed is optimal;
• With which volume certain positions should be opened (including dependence of results of trading for previous periods);
• What a maximum consolidate volume position should be etc. 

First of all every trader should understand and accept the fact of losses: they are essential part of trading as well as profit. They exist like day and night, or like two sides of one coin. No matter how simple this truth is, not any beginning trader can accept it. The beginning traders' strive to make only profitable positions (an idealism, if it can be said so) leads to the breaking of general rules of money management. It works this way: unprofitable transactions are not closed (because of the hope that sooner or later the situation at the market will change and these transactions will bring profit), and profitable transactions are closed at once after the appearance of any small floating profit (see p.5.2). 

It is not right to hope that in process of practicing of trading skills you should strive to define with the help of analysis the direction of the market and open transactions only in the direction of the future movement. It is not possible to reach this goal. In any case, nowadays science does not find any hypothetic possibility of solving this task.

What does it mean? It means that at any moment the position has its risk. In particular, there are risks of unprofitability or of gaining the profit but not in appropriate size. Also there is risk of losses. The tasks of money and risks management are:

• to minimize size of losses;
• to minimize the influence of series of losses (of forecasted sequence);
• to minimize the losses in time of unfavorable conditions for market strategy;
• to maximize the profit;
• to compensate the earlier losses in favorable conditions of market strategy, and to gain maximum profit from this situation.

Here it has to be noted that that risks and money management takes place if a trader has a certain formalized strategy. In other case (if a trader took part in trading this morning because he was in high spirit, and yesterday because of the pain in his neck) we can discuss only factual possibility (1taking into consideration the given statement) of analysis of this result. Unfortunately, the experience shows that if beginning trader (that has lack of skills and knowledge) understands suddenly that he "sees the market" (i.e. using intuition he foresees the future of the market), it leads to "spontaneous" transactions-making, that will have for the result full loss of deposit, and statement analysis will be just a try to understand, what was the reason of such a result and where the most significant mistakes were made.

It is not necessary to turn strategy into mechanic trading system, but it should include some general rules, that give answer to the main questions (see p.6.3).

The second moment that has to be noted, it is tied connection between the potential profit of strategy with its risk. From the first sight it is possible to say that this connection looks like proportional one with a note that it is of line character. It means that in general case it is possible to expect that risk decrease will lead to the decrease in profit, and the profit increase will lead to increase in risk. But there are cases when increase in risk does not lead to increase of profitability, and vice versa. The ideal goal of money and risk management is to achieve the opposite situations: the increase in profit without increase in risk and decrease of risk without decrease in profit. This goal can be achieved.

Let us note an important thing, that from mathematical point of view is an doubtless fact: if a strategy includes positive mathematical expectation (even the smallest one) with the help of money management it is possible to achieve exponential deposit growth. In other words if there is a strategy where the trading of the constant volume, it gives a growth of deposit, no matter how small it is, there is a possibility to choose for this strategy the rules of money management that will make the exponential deposit growth instead of leaner one. The conclusion of this is the existence of some optimal volume of transaction for every strategy (for self-education we can recommend to meet with materials, that are devoted to optimal Phi (a letter in Greek alphabet)). We have no such a possibility in our course to make deeper research and mathematical calculations. The general rules of money management are given below.