What is Value at Risk also known as VaR? For small investors like us, in simple terms VaR is the maximum amount of money that an investor can lose in one day in a stock market. VaR is the statistic that is used by most investment firms, hedge funds and big banks to measure the risk of their investment portfolio. Consider a trading portfolio. Its market value in US dollars today is known, but its market value tomorrow is not known. The investment bank holding that portfolio might report that its portfolio has a 1-day VaR of $5 million at the 95% confidence level. This implies that (provided usual conditions will prevail over the 1 day) the bank can expect that, with a probability of 95%, the value of its portfolio will decrease by 5 million or less during 1 day, or in other words: it can expect that with a probability of 5% (i. e. 100%-95%) the value of its portfolio will decrease by more than 5 million during 1 day. Stated yet differently, the bank can expect that the value of its portfolio will decrease by 5 million or less on 95 out of 100 usual trading days, in other words by more than 5 million on 5 out of every 100 usual trading days.
Nos keep this in mind the financial market does not has a normal distribution rather it has a skewed distribution with long tails. These long tails explain the black swan events that keep on occurring on and off in the financial market. Normal distribution assumption is mostly used to simplify the calculations but it is an erroneous assumption that can give pretty wrong results. You should also read this 39 page MIT research paper that explains the fat tails in the distribution.
This 33 page PDF by Stern School of Business, NYU explains the different methods used to measure the Value at Risk. As said in the beginning of this post, VaR is the maximum amount of money that you can lose in one single day of trading. You should calculate this value keeping whatever market that you are trading in view. After knowing this VaR, you should be prepared to lose this much to lose in one day. This should be your risk threshold. According to the above video, if you invested $100 in the Indian Stock Market, the maximum loss that you can incur in one day is close to $4 or 4%. But as said above the assumption that the stock market distribution is bell shaped also known as a Normal distribution is an erroneous assumption. In reality your VaR can be much higher.
Now here comes your skill level as a trader. It has been proven over the last hundred years that there have been people who had the skill to beat the market repeatedly. Trading is more of an art than a science. You can develop your skill level as a trader and learn how to consistently beat the market.
The video below explains how to calculate the VaR for your trading strategy. This is important as a day trader. You should know the VaR of your day trading strategy.
This is another good video by a finance professor on how to measure VaR.
Just keep this in mind most VaR models don’t work in high volatility. Most of these sophisticated VaR models failed in the market crash of 2008.