Do You Know Your Maximum Risk?


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Focusing on your maximum risk should be the focus of every investor, yet few do it. Although many have heard of risk management, few actually apply it to their investing decision-making. Worryingly many investors and traders do not realise how risky their portfolios are, and even fewer know how to measure this risk. 

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  • Understand what is maximum risk

  • Why it is so easy to take too much risk

  • Find out how you can profit from maximum risk

What is maximum risk?

It is the maximum amount of risk you have taken. Although through diversification you may feel confident that your risk is low, you may be wrong. This is because of the correlation between securities which may not be immediately obvious.

For example, if you buy the FTSE100 index and then buy oil, you may feel you have some diversification. Unfortunately due to the process of weighted average that the FTSE uses, Shell has a disproportionate strength within the index.

As a result a drop in the oil price will likely see both your oil and FTSE 100 index position drop at the same time. The same risk is prevalent in the S&P 500 index and buying a technology focused ETF.

This is due to the largest companies within the S&P 500 being at the time of writing: Apple, Microsoft, Amazon which are all tech companies. As a result when you are buying an S&P 500 technology focused ETF you are doubling your risk. This level of risk may be more than the maximum that you are prepared to take.

Are there ways of measuring risk?

Yes that are and we have listed a few below. Apart from checking if your investments are affected by the same risks, you can also measure the risk they produce using different measures. No one metric can give you a definite answer but used together they can give you a 'picture' of what to look for.

Beta risk

Is a relatively simple measure of volatility. It measures the systematic risk of a security against comparable securities. This means that if the security you have invested in has a beta of above 1, then it is more volatile than comparable investments. You may then wish to look at the return you believe you will get and see if it worth it.

Sharpe ratio

The Sharpe ratio helps displays how much risk you have taken for the return you have earned. It therefore helps you understand how risky your portfolio or a particular stock is in reality. (especially versus your perception!). This is important as many novice investors take far too much risk versus what they can afford to lose and the return they expect.

Vix index

Maximum risk can be scary .

The Vix index is also known as 'The Wall street fear gauge' and is not actually a risk measure in itself. What is provides, is a snapshot of what traders think is the current level of market risk. This is achieved by measuring the prices of near-term expiring options.  Traders can get it wrong, but it is a useful indication of potential volatility to come.

Where maximum risk was ignored

Few expected reddit day trading to become the force it has become in stock markets. Melvin capital management, a hedge fund, managed to loose a substantial amount of money and had to seek capital from other hedge funds as a result of taking on too much risk.

There was an obvious red flag which should have highlighted to Melvin that their maximum risk was simply too much. Over the first half of 2020, between 50-100% of GameStop shares were 'lent out'. This means that they are being lent out to people who are shorting them.

In effect this meant that everyone was shorting them. This represents concentration risk. If too many people are all doing the same thing, it becomes hard to exit the trade, because everyone else will try and exit at the same time.

Melvin capital do not seem to have acted on this, indeed their short was one of the biggest. If you know you are running a large of risk, you should be prepared to adjust. Think of the total amount you could loose, not just the amount you could make. Indeed trading volumes were increasing in November and December 2020 in GameStop shares which was another warning to de-risk. (Increase volume leads to a trend - and not necessarily the one you want!)

How can you profit from maximum risk?

At times you can take greater risk through holding more positions whilst profiting whether the market or asset rises or looses value. Using our earlier example, you would take a position in oil and then the opposite position in the FTSE 100 index.

For example, you would go long with your oil position (you are expecting the security to increase in value) and short in your FTSE 100 index. (Short means you expect the security to lose value). In theory if the oil price rises, you gain in your oil position and you loose in your FTSE 100 index (and vice-versa).

A word of warning, the market 'can stay irrational longer than you can stay solvent'. This means that your trade above may not work out the way you thought it would. Indeed you could get an occasion where both positions go against you. This would be a scenario where your maximum risk has become real.


You have to take a risk to make a profit. We are not suggesting you take the compliance team view that 'every risk is bad'! You are a risk manager, which means you see the opportunity but learn to mitigate the risk as well.

Understanding what is your maximum risk is a critical part of this. You may find that a trade becomes too risky, which makes you walk away. Or a trade goes the wrong way and you close it early. The first cut (closing the trade early) is the cheapest, rather than holding on and taking a larger loss later. The day you learn to loose a little to survive to the next trade is the day you become a real trader!

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