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 Stocks & Commodities V. 38:13 (14–17): Essential Math For Traders by Perry J. Kaufman
Traders, Know Thy Numbers
Essential Math For Traders
Do you understand the right way to calculate risk, reward,
and the chance of something unexpected happening in the
market? Are you sure? Just in case, here is a review of the basic
calculations and concepts that every trader should know.
T
by Perry J. Kaufman
he steady growth of volume in worldwide stock and
futures markets during the past twenty years can be
viewed as greatly increased competition for profits. An
important ingredient for success in this new regime is
a better understanding of how risk is important.
To know about your risk, you need to be able to do some
basic calculations, all of which can easily be done in Excel.
This article will summarize the most important of those cal-
culations that will help traders make better decisions.
Calculating returns
The daily returns are calculated as:
Today’s profit or loss
rt =
Original investment
You might expect to divide today’s profits by yesterday’s
equity, which is another way to do this. That would be okay,
but we will use this formula, then compound the results at the
Copyright © Technical Analysis Inc. www.Traders.com
end, which makes it unnecessary to keep track of the equity,
and the results are the same.
Creating the NAVs of your account
The net asset value (NAV), which tells you the total percent-
age return, is created by compounding the daily, weekly, or
monthly returns. This assumes that you are always fully in-
vested, which is probably not true; however, it is the standard
for creating annualized returns.
NAVt = NAVt–1 × (1 + rt )
Because we are multiplying the returns each day, the result
is a compounded return. Typically, the first value is NAV0 =
100. Note that this is the same process as indexing, that is,
turning price changes into percentages.
Some sophisticated analysts use the log of returns, but it’s
more complicated and gives exactly the same values, so I use
the first one, which is easiest.
Annualized returns
Once we have the NAVs, we can find the annualized return.
RAWPIXEL/SHUTTERSTOCK
This will allow us to compare one result with another. It re-
duces the importance of not having the same amount of data
for each market.
 Stocks & Commodities V. 38:13 (14–17): Essential Math For Traders by Perry J. Kaufman
TECHNICAL ANALYSIS BASICS
( )
( )
252
NAVt
n
AROR = –1
NAVt–n
The formula says that we divide today’s total return (net
asset value) by the starting value (usually 100 at the begin-
ning) and raise that to the number of years (in decimal), then
subtract 1. It’s easy to do in Excel:
If today’s NAV is in location B150 and the first NAV is in
location B2, then the formula is:
=(B150/B$2)^(252/149)-1
If we use weekly data, divide 52 by the number of weeks. For
monthly data, divide 12 by the number of months.
Calculating risk
Risk, which is the same as volatility, is just as important as
return. Using the same range from 2 to 150:
ARISK = AVOL = STDEV(r2, … , r150 ) × SQRT(252)
where the “r”s are the daily returns. As before, if you use
weekly data, then multiply by SQRT(52) and for monthly by
SQRT(12).
Ratio of return to risk
Having found both the annualized return and the annualized
risk, we can find the ratio—an important value for comparing
the performance of different markets, systems, or portfolios.
The industry standard is the Sharpe ratio:
AROR – Risk-free return
Sharpe ratio =
Annualized risk
The risk-free return is usually the 3-month T-bill rate, but
because all comparisons will use the same risk-free return, most
analysts ignore it. Instead they use the information ratio:
AROR
Information ratio (IR) =
ARISK
Ratios over 1.0 are very good. Ratios over 3.0 are excellent
but rare, and higher ratios are suspicious.
What are the chances?
If we believe that Google will rise by $100 over the next month,
what confidence do we have in that forecast? Is there a 50%
chance of a $100 move and a 25% chance of a $150 increase?
When we make a prediction, we want to know its chance of
success. Just because the average volatility of Microsoft has
been $8 per day does not mean that it moves $8 each day. What
is the chance of a move of $16 or $3? The standard deviation
is the most popular tool for expressing the probability of an
outcome. It can be used for many applications.
Copyright © Technical Analysis Inc. www.Traders.com
Using the daily returns, rt, as defined earlier, we calculate
the standard deviation as:
√
t
Σ i=t–n+1 (r – R )
i
Stdev =
n
or:
D2 = C2-AVERAGE(C$2:C$150), copy down D2 to D150
STDEV = SQRT(SUM(D2:D150)/149)
where R is the average of the n values of r.
Once you know the formula, it is easier to use the Excel func-
tion STDEV(D2:D150).
The standard deviation (σ in textbooks) shows how the
returns distribute around the average return. The standard
deviation is the same as volatility. For a normal distribution,
one that is symmetric, or a bell shape, the standard deviation
states that:
• 68% of the data falls between R − 1σ and R + 1σ
• 95.5% of the data falls between R − 2σ and R + 2σ
• 99.7% of the data falls between R − 3σ and R + 3σ
For example, if 1σ of the annual stock market returns is
6% and the average return is 8%, measured over the past 20
years, then 68% of the annual returns will fall between -2%
and +14%. There is 16% chance (100 – 68% divided by 2) that
you will earn more than 14% or less than -2%.
If we look at the more extreme 2σ case, then 95.5% of the
returns fall between -10% and +22%. There is only a 2.25%
chance of making more than 22% or losing more than 10%.
Figure 1 shows what this looks like.
Why is the standard deviation
important?
Knowing the risk allows you to decide how much to commit
to an asset or a trade. Most professionals target a risk of 12%,
1σ 1σ
68.26%
Mean
FIGURE 1: DISTRIBUTION. Here is a normal distribution showing the percentage
area included within the mean ±1 standard deviation.
 Stocks & Commodities V. 38:13 (14–17): Essential Math For Traders by Perry J. Kaufman

around $4.00/bushel, as low as $2.00, and as high as $12. It’s

Here are the most important
calculations that will help
traders make better decisions.
that is, one standard deviation of returns of 12%. As stated
earlier, there is a 16% chance of losing more than 12% and a
2.25% chance of losing more than 24%. If a bear market is
defined as a drop of more than 20%, this means that you’ll be
able to survive a bear market if you keep the standard devia-
tion of your returns under 12%.
During the financial crisis of 2008, the risk peaked at just
under 100%—that’s eight times greater than the recommended
target. A conscientious investor would have reduced leverage
as volatility increased, saving a great deal of the loss.
But that’s theory, not reality
While Figure 1 shows a nice, smooth curve, reality does not.
Most often, prices are skewed to the upside, called positive
skewness. It is typical of trend-following returns and also of
most stock returns because prices tend to go up.
When evaluating a price distribution, the standard deviation
doesn’t always make sense. A frequency distribution is better.
For example, using wheat over a long time period, we plot a
range of prices along the bottom and the frequency of occur-
rence at the left. Figure 3 shows that prices were most often
Normal (symmetric)
Positive distribution
skewness
a positively skewed distribution with a fat tail.
That fat tail is very important. It shows that prices can
make very large, sustained moves to the upside and smaller
moves to the downside. That’s good for a trader who is usually
long. If we were to apply the average (about $4) and standard
deviation (say, $2.50) to this wheat chart, the average minus
2 standard deviations would be a negative price ($4 – $2.50
× 2 = -$1), which is not possible.
Instead, we can sort the prices and count 10% from the lowest
actual price and 10% from the top to get those probabilities.
It is both simpler and more accurate when dealing with real
price data. Then wheat has a 10% chance of moving above $9
and a 10% chance of moving below $2 over the long term.
Instead of using prices, we could use the returns of our
trading system. Then we would have a better understanding
of our trading risk. After all, it’s not the prices that are risky,
it’s whether we are long or short when prices are moving.
When you plot the returns of a trend-following system they
should look very much like Figure 3. If you don’t have a trend-
following system, the chart could be very different.
Putting it to use:
Equalizing and controlling the risk
Now that we understand a little more about prices and risk,
we can use the information ratio to compare performance of
markets and choose the one with the highest ratio. That will
have the best payout.
To benefit the most, we need to have a portfolio of stocks or
futures markets where each position has the same initial risk.
When everything in your portfolio has the same risk, you are
Negative maximizing diversification; you are not depending on any one
skewness
stock to outperform the others. If you are pairs trading, buying
one stock and selling another, you want the hedge ratio to be
1.0, that is, each leg will have the same risk; otherwise, the
returns and risk of one stock can overwhelm the other.

Position sizing
The simplest position sizing for stocks is to divide your funds
equally across all stocks, then divide that allocation by the
Low prices High prices closing price. It assumes that volatility increases as prices
Arithmetic mean average
increase, which is not true because low-priced stocks are
Figure 2: Skewed distributions. Most system results and stock prices
have a positive skew.
the most volatile. To avoid most of the problems, don’t trade
stocks under $10.
Futures are more complicated but the sizing is more ac-
curate. Divide an equal allocation by the dollar value of the
Wheat Frequency Distribution
2500
2000
20-day average true range. Use a total of only 25% of your
investment so the reserve can absorb any losses. In futures
Frequency

1500
this way of sizing is perfectly accurate and is called volatil-
1000 ity parity. It can also be done for stocks but requires some
500 fiddling with the numbers.
0
0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 The key is low volatility
Bins Volatility changes and we need to adjust our portfolio exposure
Figure 3: Frequency distribution. Here’s a sample frequency distribution to avoid both low and high volatility. That means measuring
based on wheat prices. your daily returns using the risk calculation, then leveraging

Copyright © Technical Analysis Inc. www.Traders.com

 Stocks & Commodities V. 38:13 (14–17): Essential Math For Traders by Perry J. Kaufman
up when the annualized risk is below your target (of say, 12%
standard deviation) or deleveraging when the risk is higher.
You will be surprised to find out that the most money is lost
when you sit on a portfolio that has lower risk than your tar-
get. During good periods in the market, your return is much
lower than you expect. On the other hand, scaling down high
risk is very important but does not affect your returns nearly
as much.
With futures, leveraging and deleveraging is easy because
you have an unused, reserve of funds. To have the same flex-
ibility for stocks you need to use a double- or triple-leveraged
ETF (such as SPXL), but only invest 1/3 if you use a triple.
That gives you lots of excess capital to add leverage when the
volatility of your returns is too low.
It’s all about the numbers
Being able to understand and perform these calculations will
help you control risk and measure the success of your trading
or investment. You can compare your approach with others on
an equal footing. Risk is the most important part of trading.
Control the risk and you are on the road to success.
Copyright © Technical Analysis Inc. www.Traders.com
Perry Kaufman is a trader and financial engineer. He is
the author of many books on trading and market analysis,
including the new sixth edition (2020) of Trading Systems
And Methods (with the first edition published in 1978 as
a seminal book in the field of technical analysis), and A
Guide To Creating A Successful Algorithmic Trading Sys-
tem (2016). For questions or comments, please go to www.
kaufmansignals.com.
Further reading
Kaufman, Perry J. [2020]. Trading Systems And Methods,
Sixth Edition, Wiley.
[2016]. A Guide To Creating A Successful Algorithmic
Trading System, Wiley.
[2003]. A Short Course In Technical Trading, Wiley.
[1995]. Smarter Trading, McGraw-Hill.
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