Value at Risk

What Is Value at Risk?

Value at Risk (VaR) puts a dollar figure on your worst expected loss under normal market conditions. It uses three inputs: the time period (usually 1 day), the confidence level (usually 95% or 99%), and historical data about returns and Volatility. A portfolio with a 1-day 95% VaR of $1,000 means that on 95 out of 100 days, losses should not exceed $1,000. On those other 5 days, losses could be larger, possibly much larger.

VaR Methods

Three main approaches exist. The parametric (variance-covariance) method assumes returns follow a normal distribution, making it fast but underestimating tail risk. The historical simulation method uses actual past returns without assumptions, capturing non-normal behavior but being limited to what has already happened. Monte Carlo simulation generates thousands of random scenarios based on statistical parameters and is the most flexible but computationally intensive.

VaR for Retail Traders

While institutions use sophisticated VaR models, retail traders can apply the concept simply. Multiply your total open exposure by the pair's average daily move (using Average True Range) to get a rough daily VaR estimate. If that number exceeds 2-3% of your account, you are likely over-leveraged. This simple check, combined with proper Position Sizing, prevents the kind of concentrated risk that leads to blown accounts.