How to measure market risk
There are two main methods used to measure market risk: value-at-risk (VaR) and Beta:
- Value-at-risk is a statistical method, applied over a specific time frame, that can measure the extent of the risk (potential loss), as well as the likelihood that the loss will occur (occurrence ratio)
- Beta measures the volatility of stock, based on its previous performance, compared to the market as a whole. In other words, it determines if stocks move in the same direction as the market
However, there is no agreed-upon method for measuring market risk with either of these methods – some can be very simple, while others are quite complicated.
How to hedge market risk
Hedging is defined as holding two or more positions at the same time with the intent of offsetting any losses from one position with gains from another. Hedging market risk is one way to manage your trading risk. Many traders appreciate that certain risks are necessary – and could give them the long-term returns that they’re looking for – but hedging offers some risk protection while giving traders the exposure they want.
Your hedging strategy will depend on the market you’re trading.
An option is a financial instrument that offers the holder the right, but not the obligation, to buy or sell an asset at a set price within a set time period. Options trading gives you the opportunity to hedge against your positions through delta hedging and risk reversal.
If you’re trading the stock market, delta hedging can help you to reduce the risk of negative price movements in the underlying market. ‘Delta’ is the amount an option’s price will move when its underlying asset changes one point in price.
An options position can be hedged with another options position that has an opposing delta. For example, if a put option on a stock has a delta of -0.10, it will rise by $0.10 if the share price falls by $1. This can be hedged with a call option that has a delta of +0.10, that will rise by $0.10 if the share price increases by $1.
Or, you can create a delta hedge by opening a position using derivatives, such as spread bets or CFDs. These derivatives will have a delta of one, because the derivative moves one to one with the underlying market. For example, if you are long one call option for 100 shares with a delta of 0.55, you could hedge this delta exposure by shorting 55 shares of the stock via a spread bet or CFD trade.
Risk reversal can protect a traders’ long or short positions through put and call options. For example, if you’re a commodities trader and you open a short position on 200 units of soybeans, you can hedge it by buying a put and call option, both for 200 units of soybeans. If the price of soybeans rises, the call option will become more valuable and offset any losses to the short position. If the price of soybeans fell instead, you would profit from the short position but only to the strike price of the put option.
Futures are contracts to trade a financial market at a defined price on a fixed date in the future. With futures contracts, you can hedge against your positions on commodities, stocks, bonds and more. Futures contracts eliminate the uncertainty about the future price of a security because they enable you to lock in a price at which you want to buy or sell in the future. That way, you can offset your price movement risk.
Market risk summed up
We’ve summarised a few key points to remember on market risk below.
- Market risk affects the entire market – it can’t be avoided through portfolio diversification
- There are four main types of market risk, namely interest rate risk, equity price risk, exchange rate risk and commodity price risk
- There are several methods you can use to measure market risk, including value-at-risk and Beta
- You can hedge against market risk via options trading or with futures contracts