Stocks & Commodities V.

4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Assessing risk on Wall Street part 2

Applying the Random Walk
by Thomas A. Rorro

T he Random Walk theory lets the investor evaluate the risk of an investment before the investment is
made. In the first article in this three-part series, the potential profitability of this approach was
demonstrated. Investments were reduced to a graphic representation of profit vs. the underlying common
stock price. In this article, we will examine a technical analysis approach to the Random Walk.

Profit characteristics of basic investments

The profit characteristics of market instruments are determined by their nature. Investors avoid many of
them because of lack of understanding or an inherent fear of the risk involved. In fact, all market
instruments should be viewed as tools for building profit and controlling risk. Figure 1 displays the profit
characteristics of simple market instruments, showing both long and short positions. In these
representations, market instruments are described as a function of annualized percent profit and the
underlying common stock price.
Because- the simple market instruments are described against a common measure, they can be combined
into compound investments called hedges. Figure 2 shows several common hedging situations. The graph
describes the relationship of profitability and the underlying common stock's price. When expiring assets
(such as put or call options) are involved, the profit curves are defined for the common stock's price on
the expiration date of the option.

The distribution of stock prices

Given a graphical representation of profitability as a function of the underlying stock price, it is
reasonable to wonder what the likelihood of a given price might be. Here's where the Random Walk
theory is applied.
An investment's profit curve serves as the link between movement in the underlying common stock and
an investment's profitability. The Random Walk theory is based on the premise that stock price
movement can be modeled statistically and is a function of the underlying common stock price.
Using common sense, we can get a feel for the shape of an appropriate model of stock price movement.
From experience we know that a stock's price is more likely to move by 5 percent than by 50 percent. We
also know that a stock's price cannot fall below zero and that there is no upper limit theoretically. In
addition, if we look at the Dow Jones 30 (DJ-30) Industrials average over the past 50 years, we will
detect a definite upward trend. From this we can surmise that stocks are more likely to go up than down.
If we were to graph the probability of each possible stock price (given the above constraints) it would
take the shape of the curve in Figure 3. This graph is known to statisticians as a lognormal distribution.
Like the profit curves, which were presented earlier, the distribution is also a function of the stock price.
The mode of the distribution is the most likely future price. The mean is the average price. Since the

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Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Figure 1: The long- and short-term characteristics of simple market instruments S = Common stock
price.

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Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Figure 2: Several common hedging situations.

Figure 3: The probability of each stock price.

Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

average price (the mean) is to the right of the most likely price (the mode), we see an inherent upward
bias in the distribution of stock prices. This matches our experience with the upward trend of the DJ-30.
The graph also displays that large price movements are less likely than are small price movements. In
short, the lognormal distribution is an effective mathematical model of the likelihood of a future stock
price and is indicative of general investor experience.
All stocks are not created equal. For example, we know that banking stocks are traditionally less volatile
than technology issues. The lognormal distribution model accounts for this by adjusting the width of the
curve. Highly volatile issues will have wide, low distributions, while stable issues will have narrow,
high-peaked distributions. Neither situation is inherently superior. Market advantage is determined by an
investment's profit potential in combination with the distribution.

Taking the temperature of a stock

To determine volatility, we make an assumption that the volatility of an individual stock changes slowly
over time. Stated another way, stocks which were volatile in the recent past will be equally volatile in the
near future. This position is supported by real world considerations such as the time it takes for a
company to make acquisitions, change management, or modernize its operations. It is not uncommon for
a major change in corporate strategy to take more than five years to implement. Given a reasonably stable
environment, the investor can measure volatility by collecting 52 weeks of stock-price historical data. To
form the random variable, the log of the ratio of each week's closing price to last week's close is
determined. The standard deviation (sigma) of this data is the measure of the security's volatility. The
computed standard deviation is then used in the lognormal distribution equation and controls the width
and height of the curve.

The magic mix

Given a profit curve for an investment and the distribution of possible stock prices, the investor can make
an assessment of the worth of a candidate investment. Figure 4 shows a probability distribution
superimposed on the profit curve for a stock/put hedge.
Since the profit curve and the distribution cover all possible stock prices, an assessment of profit and loss
potential is possible. The lightly shaded area displays the potential for a profit while the dark area shows
the potential for a loss. The illustration also shows that the most likely outcome (mode) for this
investment is a loss.
Looking closely, it appears that about 60 percent of the area under the distribution corresponds to a loss.
If the underlying stock was more volatile, the distribution would be lower and wider, indicating the
greater likelihood of larger price moves. Since this scenario is more profitable with large price moves,
highly volatile stocks work best.
Figure 5 displays a stock/call option hedge along with its distribution. By visually comparing the shaded
areas of the distribution, it appears that there is an 80 percent likelihood of a profit. Since this scenario is
profitable with small stock price moves, low volatility stocks will fare well in this situation. Ultimately,
the value of an investment is based on the combination of the profit characteristics and the distribution. If
the option premium is high enough, this hedge can be of value even for highly volatile stocks.

Key parameters

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Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Figure 4: Probability distribution superimposed on the profit curve for a stock/put hedge.

Figure 5: A stock/call option hedge along with its distribution.

Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Many significant discoveries can be reduced to some simple rule or measured value. The investor making
an investment decision faces two very basic questions: What is the chance I will profit from this
investment? How much can I expect to make on it? The answer to the first question can be expressed as
the Probability of a Profit (PP). If the investment is a sure thing, the probability of a profit is 1.0. As an
example, insured bank accounts have a PP of 1.0. The answer to the second question can be expressed as
the Expected Profit (EP). In the same bank example, the expected profit is the annualized rate of return
on the account. A bank account paying 11 percent a year has an EP of 11 percent.

The Random Walk theory lets the investor evaluate the risk of an
investment before the investment is made.
The PP for an investment is determined by the percentage of the area under the distribution which
corresponds to a positive value on the profit curve. The lightly shaded areas of Figures 4 and 5
demonstrate this process. For the stock/put hedge, the PP = 0.60 (or 60 percent) and for the stock/call
hedge PP = 0.80 (80 percent).
The expected profit (EP) is determined by weighting each possible outcome of the investment by the
probability of that outcome. This process is known to the mathematician as integration. Each value on the
profit curve is multiplied by the height of the distribution and accumulated into the total. Large profits,
which are unlikely, are therefore given lower weight than profits (or losses) which are more likely. Since
both profit and loss conditions are weighted appropriately, the process results in a balanced picture of the
investment's profit potential.
The expected profit is not always a guaranteed value (as in the example of the bank account). Rather, it
represents how an investment might perform on the average. A measure of the variability in the expected
profit is Sigma in the Profit (SP). This is similar to the measure of portfolio risk which was applied using
the Capital Market Line (see the previous article). SP is determined by forming the probability-weighted
sum of the square of the profit curve value, much in the same way as the expected profit was determined.
Using PP, EP, and SP a complete picture of the worth of an investment can be drawn. The probability of
a profit provides a measure of the safety of the initial capital. The expected profit indicates the
investment's expected average rate of return. Finally, sigma of the profit is an indication of the variability
in the expected rate of return.
Portfolio theory indicates that the relationship between an investment's SP and total portfolio risk is
highly dependent upon diversification. To reduce a total portfolio's risk it is prudent to spread individual
investments among diverse industry groups. It is desirable to have six or more diverse investments in
your portfolio.

The bottom line

All this is fine in theory, but are there investments which can be uncovered using this approach? On May
9, 1985 an investment in Bally Manufacturing was available. It involved the purchase of common stock
and the short sale of warrants. Except for a longer term, warrants are equivalent to call options. The
analysis of the investment appears in Figure 6. Over the 2.5 year holding period, this investment is
expected to return 26.5 percent annually with almost no risk (PP = 0.99).

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Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Figure 6:
Stocks & Commodities V. 4:8 (309-314): Assessing risk on Wall Street part 2 Applying the Random Walk by Thomas A. Rorro

Opportunities of this caliber occur with sufficient regularity to extract 20 percent a year from the market.
The key feature of the Random Walk approach to investing is that it provides the assessment of both risk
and reward before the investment is made.
Thomas A. Rorro is a registered investment adviser and chairman of the Washington, D.C. chapter of the
American Association of Individual Investors' computer group.
For more detailed information on this application including formulas, ratios, and examples, see the book
Assessing Risk on Wall Street by Thomas A. Rorro (c) 1984.
This article is reprinted from the January/February 1986 issue of Dowline magazine, the magazine of
Dow Jones Information Services. Copyright (c) 1985-86, Dow Jones & Company, Inc., P.0. Box 300,
Princeton, NJ 08540.

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