The CAPM model and the risk analysis in trading

Risk management is an omnipresent concept in the field of trading, and it requires a good valuation of financial assets.

Risk management is an omnipresent concept in the field of trading, and it requires a good valuation of financial assets which can be achieved thanks to the CAPM (Capital Asset Pricing Model). Find out what it is in this article. 

What is the CAPM model?

CAPM is the most popular financial asset valuation model among traders. It is the work of many leading economists, including Harry Markowitz, Jack Treynor, William Sharpe, John Lintner, Jan Mossin, Merton Miller, and Eugene Fama. The idea was to accurately estimate the expected profitability in the market for a given financial asset, taking into account the risk rate it presents. It is easy to understand how the supply and demand factors for each stock help to balance the market.

To better understand the concept, we must assume that the sources of trading income are functions of the risk-free rate and the risk premium. The least risky rate of return of an investment is the risk-free rate of return. The risk itself is represented by the relationship between the volatile nature of the market and that of the asset.

The most basic CAPM formula is: Beta = Covariance (R.asset, / Variance ( It is better for any trader to rely on historical data to calculate the beta. The lower it is (ideally around 1), the more the asset is in line with market fluctuations.

How do we use it to analyze the risk in trading?

It bears repeating, success in the financial markets for any trader involves a good risk analysis of his assets. It's not just a matter of using stop-loss on key positions, but really to optimize the efficiency of trading operations by applying certain rules. This is a very delicate exercise that requires a lot of lucidity, because we are often stressed in this case.

It is important to adopt a number of principles. First of all, we must avoid using too much capital. You have to keep in mind that there is a margin to be respected, a given amount on which the leverage allows you to intervene. Then, we must not forget that losses always happen, and it is important to not allow ourselves to get down or panic to the point of launching risky operations. The ideal strategy is to set a daily loss limit for better risk management in trading.