Before we start, it’s important to emphasize that the risk score is based solely on the past performance of the stocks composing a trader’s portfolio, and as such it cannot and does not indicate future results.
The basic idea is that every portfolio is made of a group of instruments and each one of them can go up and down in value over time.
First, we measure the daily returns of the instruments (i.e. how much gain or loss the instruments have generated on a daily basis).The average of these returns give us the instrument average daily return over a period of time. We can extend the avg. return of instruments to the overall portfolio combining them on a pro rata basis.
Second, we measure how large the magnitude of the instrument’s movements (ups and downs) are compared to its avg. value over a period of time, this is what we call the variance of an instrument. We can extend this instrument variance to the portfolio variance, again combining them on a pro rata basis.
Given the portfolio avg. return and variance, calculated as above, for every trader we estimate a range of possible portfolio values that could happen in different scenarios and order them from worst to best.
Each percentage range represents a risk score that goes from 1-10, 1 being a low risk and 10 a high risk, and is meant to help you better understand the risk that your investments may pose to your equity.
There are alternatives to measuring risk and you may also wish to speak to an independent financial adviser.