Risk budget
How much loss is a strategy allowed to take, and what happens when a week outgrows that allowance?
In plain words
A risk budget is the maximum loss a strategy is permitted to suffer over a chosen period, set before the trade begins. It converts a goal, such as surviving bad weeks, into a fixed size, so that position size follows from the loss that is acceptable rather than from conviction.
Why it matters
A strategy that sizes from a stated budget behaves predictably when volatility shifts; one that sizes from enthusiasm does not. If the market moves faster or further than the budget assumed, the loss can be exceeded before any decision is made, which is a sizing failure rather than a market failure.
In a real week: BTC, week of 24 June 2019
In the week of 24 June 2019, BTC opened at 10905.95 and closed at 10854.10, a return of -0.48%, but travelled from a high of 13970.0 on Wednesday 26 June to a low of 10525.1 on Thursday 27 June, a range of 32.73%. The worst day fell -13.5% and the largest one-hour move was -7.79% on Wednesday 20:00 UTC. A budget sized from a closing return like this week's -0.48% would have allowed for far less than the high-to-low fall from 13970.0 to 10525.1.
A common mistake
Setting the budget from the size of a normal week and assuming it caps the worst week. The budget only holds if position size is reduced when measured volatility rises.