Importance of Risk Management

What is risk?

In financial markets, risk usually refers to the possibility that something can affect your investment and even result in a loss of capital, which may occur when the price of the asset you have invested in takes an unfavourable move. A variety of factors affect prices, which means traders should be aware of several types of risk and take precautions to manage them using different tools or strategies.

Investment risk can be divided into two main categories. These are systematic risk and specific risk. Investments are usually exposed to several types of risk at the same time, but it is noteworthy that risk also provides the volatility needed to capture profits.

Specific risk, or unsystematic risk, means uncertainty specific to a particular company or industry. Both internal and external factors can have an impact on a business’s revenue and profits. Operational inefficiency is an example of internal factors, while regulation is an external factor that specifically affects one product or company. 

Systematic risk, also known as market risk, affects the entire market, not just one product, company, or industry. Market risk can be caused by several factors that include geopolitical events, interest rates, natural disasters, or economic recessions.

There are also unique risk factors for online trading such as technological failures, financial crimes, and emotional decisions.

The risk-reward concept

Moving prices pose a risk to the investment, but it wouldn’t be possible for traders to make profit if prices always remained the same.

This means that the concept of risk and reward is at the core of financial markets. Risk and reward go hand-in-hand because the amount of risk is tied to the size of the possible return. Usually, the higher the risk you are willing to take, the higher the potential return will be.

When trading, it’s always important to assess the possible outcomes of your trade and get a realistic idea of the potential risks and returns. The risk-reward ratio helps traders to compare the expected return to the amount of risk involved in the trade. Often, 1:3 is considered the ideal risk-reward ratio.

A simple formula to calculate your risk-reward ratio is:

Risk-return Ratio = Potential Loss / Potential Gain

Get to know your risk appetite 

People tolerate risk differently, and before you start trading it’s important to assess your own risk tolerance. Consider factors such your financial goals, the amount of time you have and even your personality.

If you’re not sure what your risk appetite is, here’s some examples of common risk profiles:

• Low risk

A low risk appetite means that traders are interested in small gains and avoiding loss, rather than chasing bigger potential returns and losses. They tend to focus on less volatile products and have a cautious approach to risk management, often aiming to preserve money and achieve reliable returns over longer periods of time.

• Moderate risk

Traders with a moderate risk appetite are open to slightly higher levels of risk in the pursuit of higher returns. These traders are willing to take on increased volatility in pursuit of potentially higher and faster returns. They often diversify their focus across a range of financial products such as shares and ETFs.

• High risk

When it comes to high risk appetites, traders are known for taking on significant levels of risk in exchange for the potential of maximum rewards. They often invest in high-volatility products, which can experience rapid and substantial price changes.

Traders with a larger risk appetite will often use leverage, which allows them to control much larger trade sizes by investing a margin (percentage) of the deposit. As leverage amplifies the potential profits, it’s important to note that potential losses will be equally amplified as well.

What does risk management mean?

Risk management means acknowledging the risks involved in trading and taking action to handle those risks. Risk management strategies and tools help traders to limit how much money they can lose and reduce the risk of open trades closing unexpectedly due to insufficient funds in their trading account.

You can manage your risk by identifying and evaluating any potential challenges that may affect your trading plan. By thinking about the factors that can affect the possible outcome of your trade, you can prepare for these risks by choosing strategies and tools that can help prevent them.

Your long-term success in trading will rely on how well you use your risk management tools. Losses are often unavoidable in trading and after losing money, it’s natural to get frustrated. It’s important to not let emotions have control over your trading decisions, as this can lead to uneducated guesses and even more losses.

Common risk management strategies and tools

There are plenty of risk management strategies and tools available. Every trader has a unique trading plan, so it is important to find the tools that work best for you.

Stop loss orders are one of the most popular and commonly used tools to control risk on your trades. If you set a stop loss order on your trading platform, it means an open position will be automatically closed if unexpected volatility appears, and the price of the underlying asset reaches the decided value. As traders can choose the price at which the stop loss order will be executed with, it can be adjusted to their own risk appetite.

Diversification means creating a trading portfolio that doesn’t put all your eggs in one basket. This is achieved through investing in different assets, companies, and industries. The more diversified your portfolio of assets is, the less vulnerable you are to sudden changes affecting one asset group, company, or industry.

Position sizing means determining the ideal position size for your trades. Traders should be aware how much risk the size of their positions includes and not place trades where the possible losses exceed your risk appetite.

Choosing a leverage that fits your risk appetite is an important way of limiting risks when trading leveraged products. Leverage multiplies your potential profits because you can trade larger volumes with a small deposit, but it also exposes you to larger losses because the profit and loss are calculated based on the size of the entire position. Before using leverage, ensure you have done realistic profit and loss calculations.

Hedging means taking several opposing positions at the same time. A trader opens a new position, a hedge, to reduce the risk that a sudden change in the price of an asset may cause to an already existing position. Unfavourable movements can happen in the market, and you cannot prevent them, but hedging is a kind of insurance for the capital invested in the original position, as less risk is held in one place.