Not long ago, OANDA posted a blog entry discussing another of the tools they have available for the use of forex traders. This particular tool is a Value-at-Risk (VaR) calculator.
The concept of VaR developed in the 1990s as financial institutions looked for a way to evaluate their unified risks in the wake of the Crash of 1987. It has certainly taken its fair share of lumps and criticism, particularly in the wake of the Financial Crisis, but does have value if used properly.
What the OANDA tool basically does is give you an indication of how a given currency pair traded in terms of price movements over a given recent period of time. How far back that goes depends on your choices of granularity (time frame, number of bars spanned). You can also choose from different Confidence Levels, which basically means how much of the time the market exhibited price moves of a certain size or smaller.
For example, I plugged in EUR/USD at the 95% Confidence Level looking at 1-day candles and a 1-day trade time frame. The tool gave me the following report:
VaR at 95% Confidence Level = 172 pips.
Over the past 9 months, 3 weeks, 4 days and 12 hours, 95% of 1 day periods, price movement was less than 172 pips.
In other words, there was a 5% chance that price moved more than 172 pips in the last 9 months, 3 weeks, 4 days and 12 hours.
When I change to a 30-minute candle and a 10-period time frame, I get this:
VaR at 95% Confidence Level = 90 pips.
Over the past 6 days and 6 hours, 95% of 5 hour periods, price movement was less than 90 pips.
In other words, there was a 5% chance that price moved more than 90 pips in the last 6 days and 6 hours.
To best use these figures, you should convert them into values relative to your account. For example, if you have a $5000 account and are trading a mini (10,000 unit) lot EUR/USD position, the 90 pips noted in the second example above would represent 1.8% of your account. That’s 90 pips at $1.00 per pip, for $90 in risk, divided by the $5000 account value.
Whether you are doing your own trading, or monitoring your portfolio of positions in an autotrading or social investing account like Trade Leaders, this sort of tool can come in handy to provide you with an idea of the type of risk you have on.
That said, there are a couple things you absolutely must keep in mind.
First, VaR is a backward looking indicator. It will tell you how the market traded in the past, but cannot tell you how the market will trade in the future. Maybe it will be more volatile. Maybe it will be less volatile. As a result, VaR works best if you can integrate it with something which will help you anticipate changes in volatility.
Second, VaR provides no information on how bad things can get beyond the Confidence Level you set. It’s fine to say 95% or 99% of the time the market move X number of pips or fewer. The problem comes in that 5% or 1% of the time when the market moves more than X pips. It could only be a couple of extra pips, or it could be hundreds of extra pips in the case of a black swan type of event. VaR is good for helping anticipate and plan for “normal” market activity, but you need to have something beyond VaR to help you deal with non-normal market situations so you are protected against worst case scenario type moves.
One more item of note. If you are holding positions in multiple different currency pairs in your account, you should look at the VaR of your net exposures, not of the individual positions. For example, if you were to be long EUR/USD and short EUR/GBP, then your net position would be long GBP/USD (or at least mostly so), meaning you would want to look at the VaR of that because that would be your primary risk. The limit to the OANDA tool is that it can only show you one currency pair, so if you have multiple pairs in action which don’t offset and net out like the example here (like being long EUR/USD and short USD/JPY at the same time), you need to factor a correlation adjustment in to come up with a portfolio VaR.
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