The first risk limit we will look at is quite intuitive and is called stop-loss, or max-loss. This limit is the maximum amount of money a strategy is allowed to lose, that is, the minimum PnL allowed. This often has a notion of a time frame for that loss, meaning stop-loss can be for a day, for a week, for a month, or for the entire lifetime of the strategy. A stop-loss with a time frame of a day means that if the strategy loses a stop-loss amount of money in a single day, it is not allowed to trade any more on that day, but can resume the next day. Similarly, for a stop-loss amount in a week, it is not allowed to trade anymore for that week, but can resume next week.

Now, let's compute stop-loss levels on a week and month for the volatility adjusted mean reversion strategy, as shown in the following code:

num_days = len(results.index)

pnl = results['PnL']

weekly_losses = []
monthly_losses = []

for i in range(0, num_days):
  if i >= 5 and pnl[i - 5] > pnl[i]:
    weekly_losses.append(pnl[i] - pnl[i - 5])

  if i >= 20 and pnl[i - 20] > pnl[i]:
    monthly_losses.append(pnl[i] - pnl[i - 20])

plt.hist(weekly_losses, 50)
plt.gca().set(title='Weekly Loss Distribution', xlabel='$', ylabel='Frequency')
plt.show()

plt.hist(monthly_losses, 50)
plt.gca().set(title='Monthly Loss Distribution', xlabel='$', ylabel='Frequency')
plt.show()

The code will return the following plots as output. Let's have a look at the weekly loss distribution plot shown here:

Now, let's take a look at the monthly loss distribution plot shown here:

The plots show the distribution of weekly and monthly losses. From these, we can observe the following:

• A weekly loss of anything more than $4K and a monthly loss of anything more than $6K is highly unexpected.
• A weekly loss of more than $12K and a monthly loss of $14K have never happened, so it can be considered an unprecedented event, but we will revisit this later.