Risk Score What it is and how it is Calculated
The Risk Score is a key feature offered by eToro, which enables you to manage your risk and helps you understand the risk score of other traders when considering copying them or investing in CopyPortfolios.
What is a Risk Score?
The Risk Score is a numeric value, ranging from 0-10, where 10 is extremely high risk and 0 is extremely low risk. These numbers are not arbitrary: There is a thorough calculation behind them. You can find a detailed explanation of how it is calculated below. However, for general reference, a score of 1-3 is considered low, 4-6 is medium and 7-10 is high.
How is the Risk Score Calculated?
The basic idea is that every instrument has an average daily movement, which indicates its volatility. For example, let’s say the market price of instrument X shifts on average around 2% a day (during a given day, it will usually go up or down by around 2% from its price at the beginning of the day). This is basically its daily standard deviation, which is one of the key fundamental risk measures that analysts, portfolio managers, wealth management advisors and financial planners use.
Statistically, if we multiply the average standard deviation by three, we create a range that will be correct 99% of the time. So, in our example, 99% of the time, instrument X will move up or down by a maximum of 6% in a single day.
Starting with the above, we can get a general idea of how volatile a certain asset is. Or in other words: How risky it is. However, other factors also need to be taken into account. For example, when applying leverage, the risk increases.
Calculating Risk Score for People
The Risk Score is calculated using an algorithm that combines various factors. When calculating the Risk Score for an eToro trader or investor, the algorithm considers the following:
- The volatility of each instrument in that person’s portfolio: Not only does each asset have its own risk factor, but some assets can influence others. For example, gold is a common hedging instrument for currency traders, and, therefore, a portfolio containing both assets with low leverage may have a lower risk score.
- The direction of each position: On eToro, you can open a short (SELL) position on any instrument. Some traders and investors use this option to hedge their investments in what is known as a “long/short strategy.” Generally, if all of the positions in the portfolio are in the same direction and correlated with one another, the portfolio will be considered riskier than a portfolio that has a combination of short and long (BUY) positions for the same asset.
- The percentage of equity being invested in open positions: The relative size of each trade is important. A trader investing a substantial amount of their equity in a single instrument or one asset class is considered a higher risk than a more diversified investor.
- The leverage used: Higher leverage means more exposure in the position, leading to more volatility and, therefore, more risk.
The Risk Score for each trader is calculated daily and each trader’s average score is presented on their portfolio.
Calculating Risk Score for CopyPortfolios
The calculation is quite similar to that done with traders. For Market Portfolios, each asset’s risk is calculated and then the data is consolidated into a single figure while taking the weighting of each instrument in the portfolio into consideration.
For Top Trader Portfolios, the risk score for each trader is calculated using the algorithm above and the overall score is then calculated while taking the weighting of each trader in the portfolio into account.
The Risk Score is a great tool for eToro traders and investors to gain a better understanding of the portfolios and people in which they invest. We recommend always taking it into account, as part of your overall risk management strategy.
The content above is intended for educational purposes only, and should not be considered as investment advice.