What Is Value At Risk, And How Do Traders Use It In Trading?

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Summary:

Value at Risk (VaR) is a widely used risk metric that helps traders and institutions estimate potential losses over a given timeframe. By quantifying downside risk, VaR provides a structured way to assess exposure across different assets and strategies. This article explains the VaR definition, how it’s calculated, and how traders use it in real-world markets to refine risk management.

What Does VaR Stand For?

So what is Value at Risk? Value at Risk, abbreviated to VaR, is a statistical measure used to estimate how much a trader, portfolio, or institution could lose over a set period under normal market conditions. It provides a single risk figure, making comparison of different assets, portfolios, or strategies more straightforward.

VaR is defined by three key components:

● Time Horizon – The period over which the potential loss is measured, such as one day, week, or month.

● Confidence Level – Expressed as a percentage, typically 95% or 99%, indicating the probability that losses will not exceed the calculated VaR amount.

● Potential Loss – The estimated maximum amount or percentage that could be lost within the given timeframe, based on historical or simulated market movements.

For example, if a portfolio’s Value at Risk has a one-day 95% risk estimate of £10,000, it means that under normal conditions, there is a 95% chance that losses won’t exceed £10,000 in a single day. However, the remaining 5% represents extreme events where losses could be greater.

VaR is widely used in trading, portfolio management, and regulatory frameworks because it quantifies risk in monetary terms. It helps traders set position limits, assess exposure, and compare risk across different assets. However, while VaR is useful, it does not account for rare but extreme losses, which is why it’s often combined with other risk measures.

How Value at Risk Is Calculated

There are three main ways to calculate VaR, each with its own approach to estimating potential losses: the historical method, the variance-covariance method, and the Monte Carlo simulation. Each method has strengths and weaknesses, and traders often use a combination to cross-check risk assessments.

1. Historical Method

This approach looks at past market data to estimate future risk. It takes the historical returns of an asset or portfolio over a given period—say, the last 250 trading days—and ranks them from worst to best. The VaR is then set at the percentile corresponding to the chosen confidence level.For example, in a 95% confidence level VaR calculation using 250 days of data, the worst 5% (12.5 worst days) would indicate the expected loss threshold. If the 13th worst loss was £8,000, that would be the VaR estimate. This method is simple and doesn’t assume a normal distribution, but it relies on past data, which may not capture extreme events.

2. Variance-Covariance Method

The Variance-Covariance (VCV) method assumes that potential returns follow a normal distribution and estimates risk using standard deviation (volatility).One of the main advantages of the VCV method is its simplicity and efficiency, particularly for portfolios with multiple assets. However, its accuracy depends on the assumption that potential returns are normally distributed, which may not always hold, especially during extreme market conditions.

3. Monte Carlo Simulation

Monte Carlo simulations generate thousands of hypothetical market scenarios based on random price movements. It models different potential outcomes by simulating how prices might evolve based on past volatility and correlations. The resulting dataset is then analysed to determine the percentile-based VaR estimate.This method is more flexible and can handle complex portfolios but is computationally intensive and requires strong assumptions about price behaviour.

How Traders Use Value at Risk in Trading

Traders use Value-at-Risk models to measure potential losses, manage exposure, and make decisions about position sizing. Since VaR quantifies risk in monetary terms, it provides a clear benchmark for setting risk limits on individual trades or entire portfolios.One of the most practical applications of VaR is in position sizing. A trader managing a £500,000 portfolio might have a risk tolerance of 1% per trade, meaning they are comfortable with a potential £5,000 loss per trade. By calculating VaR, they can assess whether a given trade aligns with this limit and adjust the position size accordingly.

Hedge funds, proprietary trading firms, and institutional investors use VaR to allocate capital efficiently. If two trades have the same expected returns but one has a higher VaR, a trader may adjust exposure to avoid exceeding risk limits. Large institutions also use portfolio-wide VaR to monitor overall exposure and assess whether they need to hedge positions.

Another key use is stress testing. Traders often compare historical VaR to actual market moves, especially during volatile periods, to gauge whether their risk model holds up. If markets experience larger-than-expected losses, traders may refine their approach by incorporating additional risk measures like Conditional VaR (CVaR) or adjusting exposure to tail risks.Ultimately, VaR is a risk filter—it doesn’t dictate decisions but helps traders identify when exposure might be higher than expected, so they can adjust accordingly.

Strengths and Limitations of VaR

Value at Risk is widely used in trading and portfolio management because it provides a single, quantifiable measure of potential loss. However, while it’s useful for assessing risk, it has limitations that traders need to be aware of.

Strengths of VaR

● Straightforward risk measure: VaR condenses complex risk exposure into a single number, making comparison of different assets and strategies more straightforward.

● Applicable across asset classes: It works for stocks, forex, commodities, and fixed income, allowing traders to standardise risk assessment across different markets.

● Useful for position sizing: Traders can align their risk limits with VaR calculations to try keeping exposure within predefined boundaries.

● Regulatory and institutional use: Banks and hedge funds use VaR to comply with risk management regulations.

Limitations of VaR

● Does not account for extreme losses: VaR shows the potential loss up to a given confidence level but does not measure tail risk—severe market events beyond that threshold.

● Assumes normal market conditions: Some VaR methods rely on historical data or normal distribution assumptions, which may not hold during volatile periods or financial crises.

● Sensitive to calculation method: Different approaches (historical, variance-covariance, Monte Carlo) can produce different VaR figures, leading to inconsistencies in risk estimation.

● Past data may not reflect future risks: Markets evolve and historical price patterns may not always be reliable indicators of future behaviour.

Because of these limitations, traders often combine VaR with other risk measures, such as Conditional VaR (CVaR), drawdowns, and volatility analysis, for a more comprehensive risk assessment.

Real-World Examples of VaR in Financial Markets

Value at Risk is used by traders, hedge funds, and financial institutions to assess market exposure and manage risk. It plays a key role in everything from daily trading operations to large-scale regulatory compliance.

J.P. Morgan and the Birth of VaR

VaR gained prominence in the 1990s when J.P. Morgan developed its RiskMetrics system, which set a standard for institutional risk measurement. The firm used VaR to estimate potential losses across its trading desks, providing a consistent risk measure for its global operations. This approach became so influential that it was later adopted by regulators and central banks.

Long-Term Capital Management (LTCM) – A VaR Misstep

It’s believed that the reliance of the hedge fund Long-Term Capital Management (LTCM) on VaR to manage its highly leveraged positions in the late 1990s led to the fund’s collapse. While its models suggested limited downside risk, LTCM’s reliance on normal market conditions led to catastrophic losses when a position in Russian debt unravelled. The fund’s VaR calculations underestimated extreme market moves, contributing to a collapse that required a $3.6 billion bailout from major banks.

Goldman Sachs During the 2008 Crisis

During the 2008 financial crisis, Goldman Sachs relied on VaR to monitor trading risk. At the peak of market volatility in late 2008, its daily VaR jumped significantly, highlighting the increased risk in its portfolio. The firm adjusted exposure accordingly, reducing positions in high-risk assets to manage potential losses.

FAQ

What Is VaR?

The Value at Risk, or VaR, meaning refers to a statistical measure used to estimate the potential loss of an asset, portfolio, or trading strategy over a specific timeframe with a given confidence level. It helps traders and institutions assess market exposure and manage risk.

What Does VaR Mean in Trading?

In trading, VaR quantifies the potential downside of a position or portfolio. It provides a single number that represents the maximum expected loss over a set period, such as one day or one week, under normal market conditions.

How to Calculate Value at Risk?

VaR is typically calculated using three methods: historical simulation, which uses past market data; the variance-covariance method, which assumes a normal distribution of potential returns; and Monte Carlo simulation, which generates potential future price movements to estimate risk.

What Is a VaR Strategy?

A VaR strategy involves using VaR to set position limits, manage exposure, and allocate capital efficiently. Traders and institutions often integrate VaR into broader risk management frameworks to balance potential risk and returns.

What Does 95% VaR Mean?

A 95% VaR means there is a 95% probability that losses will not exceed the calculated VaR amount over the chosen period. The remaining 5% represents extreme market events where losses could be higher.

Source: FXOpen

Risk Warnings and Disclaimers

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Adam

Economic

J.P.Morgan now expects the U.S. Federal Reserve to cut interest rates by 25 basis points at its September meeting, citing signs of weakness in the labor market and uncertainty around President Donald Trump's latest Fed nomination.

The brokerage had earlier forecast one 25 basis point rate cut in December but said in a note on Thursday that the risks now point to an earlier move, followed by three more quarter-point cuts before the Fed pauses.

"For Powell, the risk management considerations at the next meeting may go beyond balancing employment and inflation risks," J.P.Morgan analyst Michael Feroli wrote.

Trump on Thursday nominated Stephen Miran, Chair of the Council of Economic Advisers, to fill a temporary seat on the Fed Board, replacing outgoing Governor Adriana Kugler.

Miran's confirmation before the September 16–17 policy meeting remains uncertain, but JPM said his presence could increase divisions within the rate-setting committee.

The move follows months of Trump pressuring the Fed to cut rates, often clashing with Chair Jerome Powell over keeping policy tight. "In the off chance Miran is governor by the time of the next meeting, that could imply three dissents. That’s a lot of dissents," Feroli said.

The Fed's decision may hinge on August jobs data. JPM said an unemployment rate of 4.4% or higher could justify a larger cut, while a lower reading may prompt resistance from policymakers focused on inflation.

Separately, the JPM note said that Fed Governor Christopher Waller is emerging as the frontrunner to succeed Jerome Powell as Fed Chair, a move it said would likely be welcomed by financial markets.

Analysts at Barclays echoed the sentiment, saying Waller's appointment would reduce uncertainty around how the Fed responds to economic data, which could support longer-dated bonds.

Traders now price in a 91.4% chance of a rate cut in September, compared with 37.7% last week, according to CME Group's FedWatch tool.

Source: Reuters

To stay updated on all economic events of today, please check out our Economic calendar

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James Whitman

Economic

Political

Switzerland is continuing discussions with the United States about reducing potentially crippling import duties, its government said on Friday, as the country's gold industry warned exports of gold bars to the U.S. could be severely impacted by a 39% tariff.

The tariff talks in Washington are being led by Helene Budliger Artieda, head of the State Secretariat for Economic Affairs (SECO), and come after the import levy - among the highest of any applied under President Donald Trump's global trade reset - took effect on Thursday.

A last-ditch Swiss trip led by President Karin Keller-Sutter failed to produce a better deal.

"Discussions with the United States are ongoing," SECO said in a statement to Reuters on Friday. "The discussions have consistently focused on reducing the additional U.S. tariffs."

SECO said it would give no further details on the talks, which could include further concessions Switzerland may offer the U.S. in return for lower tariffs.

No discussions were scheduled for Friday, although they are due to continue next week on a technical level, a Swiss source said, without giving further details.

The Swiss precious metals association on Friday said it was concerned about an increase in tariffs on gold exports to the United States to 39%.

Gold bars of 1 kg and 100 oz were previously exempt from U.S. tariffs, but country-specific tariffs may now apply.

Switzerland is the world's largest gold refining centre, with up to 70% of gold produced annually worldwide melted down and processed at the five refineries in the country.

The country imports gold bars and resizes them for the U.S. market. Switzerland exported gold bars worth 7.86 billion Swiss francs ($9.7 billion) to the U.S. last year, according to customs data.

"We are particularly concerned about the implications of the tariffs for the gold industry and the physical exchange of gold with the U.S., a long-standing and historical partner for Switzerland," said Christoph Wild, president of the Swiss Association of Manufacturers and Traders in Precious Metals.

"With a tariff of 39%, exports of gold bars will definitely be stopped to the U.S.," Wild told Reuters.

Economist Hans Gersbach, from the KOF Economic Institute at ETH, a university in Zurich, estimated that 7,500 to 15,000 jobs could be lost in Switzerland as a result of the U.S. tariffs.

"The effect will be severe in some industries like watches, machinery and precision instruments," Gersbach said.

"If pharma was also targeted, the figure would be higher," he added, although no figure has yet been calculated.

Source: Reuters

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Adam

Economic

Chinese regulators have asked local brokers and other bodies to stop research publication and seminars to endorse stablecoins in a bid to check the asset class and avoid instability, Bloomberg News reported on Friday.

Some brokerages and think tanks received guidance from market regulators in late July and earlier this month, pushing them to cancel seminars and discontinue dissemination of research on stablecoins, the report said, citing people familiar with the matter.

Regulators are also concerned that stablecoins could be exploited as a new tool for fraudulent activities in mainland China, the Bloomberg report said.

China Securities Regulatory Commission and the People's Bank of China did not immediately respond to a Reuters request for comment. Reuters could not immediately verify the report.

Stablecoins are a type of cryptocurrency designed to maintain a constant value and are usually pegged to a fiat currency such as the U.S. dollar and are commonly used by crypto traders to move funds between tokens.

While China's 2021 ban on cryptocurrency remains in effect on the mainland, Hong Kong passed a stablecoin bill earlier this year to boost its status as a global digital asset hub.

Source: Reuters

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James Whitman

Political

Russia-Ukraine Conflict

Washington and Moscow are aiming to reach a deal to halt the war in Ukraine that would lock in Russia’s occupation of territory seized during its military invasion, according to people familiar with the matter.

US and Russian officials are working toward an agreement on territories for a planned summit meeting between Presidents Donald Trump and Vladimir Putin as early as next week, the people said, speaking on condition of anonymity to discuss private deliberations. The US is working to get buy-in from Ukraine and its European allies on the deal, which is far from certain, the people said.

Putin is demanding that Ukraine cede its entire eastern Donbas area to Russia as well as Crimea, which his forces illegally annexed in 2014. That would require Ukrainian President Volodymyr Zelenskiy to order a withdrawal of troops from parts of the Luhansk and Donetsk regions still held by Kyiv, handing Russia a victory that its army couldn’t achieve militarily since the start of the full-scale invasion in February 2022.

Such an outcome would represent a major win for Putin, who has long sought direct negotiations with the US on terms for ending the war that he started, sidelining Ukraine and its European allies. Zelenskiy risks being presented with a take-it-or-leave-it deal to accept the loss of Ukrainian territory, while Europe fears it would be left to monitor a ceasefire as Putin rebuilds his forces.

Russia would halt its offensive in the Kherson and Zaporizhzhia regions of Ukraine along the current battlelines as part of the deal, the people said. They cautioned that the terms and plans of the accord were still in flux and could still change.

It’s unclear if Moscow is prepared to give up any land that it currently occupies, which includes the Zaporizhzhia nuclear power plant, the largest in Europe.

The White House didn’t reply to a request to comment. Kremlin spokesman Dmitry Peskov didn’t immediately respond to a request to comment.

Ukraine declined to comment on the proposals.

The agreement aims essentially to freeze the war and pave the way for a ceasefire and technical talks on a definitive peace settlement, the people said. The US had earlier been pushing for Russia to agree first to an unconditional ceasefire to create space for negotiations on ending the war that’s now in its fourth year.

Having returned to the White House in January on a pledge to rapidly resolve Europe’s worst conflict since World War II, Trump has expressed increasing frustration with Putin’s refusal to agree to a ceasefire. The two leaders held six phone calls since February and Trump’s envoy Steve Witkoff met with Putin five times in Russia to try to broker an agreement.

Source: Bloomberg

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Damon

Palestinian-Israeli conflict

SEVENOAKS, England, Aug 8 (Reuters) - Britain and the United States may disagree about how to address the crisis in Gaza but they share common goals in the region, U.S. Vice President JD Vance said at the start of a meeting with British Foreign Secretary David Lammy in southern England.

Vance, who has previously criticised Britain and its governing Labour Party, landed with his wife Usha and their three children in London before heading to Chevening, the large, red-brick country residence used by the British foreign minister.

Appearing before reporters and TV cameras, the two leaders exuded plenty of bonhomie, with Lammy recommending Vance enjoy a coastal walk in Kent and the vice president professing his "love" for Britain.

Asked about Britain's plan to recognise Palestine, Vance said the U.S. and Britain had a common goal to resolve the crisis in the Middle East, adding: "We may have some disagreements about how exactly to accomplish that goal, and we'll talk about that today."

Vance also reiterated that the U.S. had no plans to recognise a Palestinian state, saying he didn't know what recognition actually meant, "given the lack of a functional government there."

Britain, by contrast, has taken a harder stance against Israel, declaring its intention to recognise Palestine along with France and Canada to put pressure on Israeli leader Benjamin Netanyahu over the continuing conflict and humanitarian crisis in Gaza.

Earlier on Friday, Vance and Lammy also went fishing in the lake behind Chevening House, appearing relaxed in blue button-down shirts and sharing a laugh.

Vance joked to reporters that the "one strain on the special relationship" between Britain and the U.S. was that all his children had caught fish but that the British foreign minister had not.

"Before beginning our bilateral, the Vice President gave me fishing tips, Kentucky style," Lammy said in a post on X.

After spending two nights in Chevening's bucolic surroundings with Lammy, the Vances will travel to the Cotswolds, a picturesque area of English countryside and a popular retreat for wealthy and influential figures, from footballers and film stars to media and political figures.

The visit comes amid heightened transatlantic tensions, domestic political shifts in both countries and increased attention on Vance's foreign policy views as he emerges as a key figure in President Donald Trump’s administration.

A source familiar with the planning described the trip as a working visit that will include several official engagements, meetings and visits to cultural sites. Vance is also expected to meet with U.S. troops.

Vance and Lammy will also discuss the war in Ukraine, the pair told reporters.

Close to Chevening House, a small group of protesters had gathered, some waving Palestinian flags and one holding up a sign showing a meme of a bald Vance.

Source: Reuters

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Samantha Luan

Cryptocurrency

Political

US President Donald Trump signed an executive order on Thursday, aimed at eliminating practices by banks and their regulators that result in certain customers being denied access to financial services for ideological reasons.The order directs federal banking regulators to remove reputational risk standards from their guidance and training materials, and identify financial institutions that engaged in unlawful “debanking” in the past, the White House said in a fact sheet published after the signing.

Federal authorities are also directed to impose fines or take other remedial measures they deem appropriate on institutions that are found to have had such policies.And regulators will also be required to review complaint data, and refer instances of unlawful debanking based on religion, to the US Justice Department. Financial institutions under the jurisdiction of the Small Business Administration, will also be required to make reasonable efforts to reinstate clients who were unlawfully denied services.

“President Trump believes that no American should be denied access to financial services because of their political or religious beliefs, and that banking decisions must solely be made on the basis of individualised, objective, and risk-based analyses,” the White House said.Some of the nation’s biggest banks have been accused by the Trump administration of shutting customer accounts for political or religious reasons. And many conservatives have complained that major Wall Street firms have debanked gunmakers, fossil-fuel companies, religious groups, and cryptocurrency firms.

Trump signed the order alongside an action designed to increase access to alternative assets such as private equity, real estate and cryptocurrency in retirement accounts Thursday afternoon, at the White House. Details of the debanking executive order were reported earlier by Fox Business.Trump earlier this week said banks had discriminated against him in the past. JPMorgan Chase & Co had asked him to close accounts he held for decades within 20 days, and Bank of America Corp declined his attempt to deposit more than US$1 billion (RM4.23 billion), he said in a CNBC interview. Regulators in the Biden administration had been ordered to “destroy Trump,” the president said.

Both JPMorgan and Bank of America have denied rejecting business on ideological grounds.The executive order requires the lenders to examine their processes for deciding whether to close accounts, and asks regulators to remove references to so-called “reputational risk” posed by customers — a practice banks have said led to decisions not to deal with certain customers or industries.

Bank of America, the second-largest US bank, had restricted lending to companies that make assault-style guns used for non-military purposes, following shootings at a high school in Florida in 2018. Citigroup Inc also announced its own set of restrictions for clients selling guns that year.Bank of America went on to loosen its gun restrictions and made similar changes to its energy-lending policies, including dropping a blanket ban on financing for Arctic drilling. Then in June, Citigroup ended a seven-year policy that placed restrictions on firearms sales by its retail sector clients, citing recent legislative developments, and concerns over access to banking services.

Bills have been reintroduced in Congress this year, that would prohibit banks from accessing certain lending programmes if they deny “fair access” to their services. The “Fair Access to Banking Act” has gained support from groups in the firearms industry.