Risk Management

It’s often said that trading the financial markets is effectively the trading of risk.

The risk in any situation is Uncertainty

'The chance of an outcome being different than expected'

What exactly is the risk in terms of finance?

'The chance of an investment's actual return being different than expected'

Example: "By buying EUR/USD, I effectively have the opinion the Euro will strengthen against the US Dollar"

The risk is the possibility of the Euro weakening against the US Dollar – an adverse movement

In other words, financial risk is the possibility of losing part or all of your original investment

If trading the financial markets is effectively the trading of risk, then why would we “risk” the market goes against us?

Although risk makes us susceptible to adverse movements in the market, risk also presents the potential/opportunity to make huge amounts of money.

Risk = opportunity And The higher the risk, the higher the potential opportunity

The Risk/Reward Trade-Off

The higher the risk an investor takes on, the higher the potential returns should be in order to compensate the increased risk. This is known as The Risk/Reward Trade-Off

Low Risk = Low Return

High Risk = High Return

Risk Management Tools

Stop Loss Orders

Stop Loss Orders are the single most important risk management tool and should always be employed when trading

Types of Stops

1.Breakeven Stops – executed at the point at which gains equal losses

2.Time Stops – it relies on a certain period of time elapsing before the order is executed

3.Trailing stops - set at a percentage level below the market price. It allows you to let profits run on and minimize your losses at the same time.

Risk Tolerance

Low-risk investments will have lower return potential than high-risk investments.

Low Risk = Potential Low Return

Medium Risk = Potential Medium Return

High Risk = Potential High Return

Your trading style will often define how low or high risk your strategy is but even the greatest investment or trading strategies are of little help if you do not control risk

Your Risk Tolerance is the degree of uncertainty you can handle regarding a potential loss or decrease in your investment portfolio value

Risk tolerance will be different for each person and how much you can handle generally depends on three things;

  • Income - Your personal income and personal situation e.g. A person on a low salary about to get married will be likely to have a low to moderate risk appetite and will, therefore, most probably have lower risk capital available than a single person on a median salary
  • Time Horizon - The amount of time you plan to keep your money invested. Longer time horizons are associated with less risk than shorter time horizons
  • Investment Objectives - The greater your financial goals, the greater the risk you will likely have to take on

Mitigating the Risk

What is asset allocation?

Asset allocation is an investment strategy aimed to balance risk and reward. It shares out the portfolio's assets according to your investment goals, risk tolerance and time horizon.

Different asset allocations have different levels of risk, below is an example of the risk associated with a selection of asset allocations;

Diversification

A risk management technique that aims to reduce risk through mixing up your portfolio with many different investments

Diversification is particularly helpful when trying to offset unsystematic risk, which is industry/company specific.

Diversification is based on the rationale that any bad performers should be offset by good performers thus smoothing out unsystematic risk.

Controlling Your Leverage

Remember! Leverage can be tailored according to your risk appetite. If you are risk-averse, trade on higher margin requirements to reduce your leverage

Be Careful! Learn to control your leverage, treat it as a credit card, be careful not to get carried away with money you don’t have just because it’s available!

Technical Analysis

The technical analysis serves as an important aid in risk management

We can use it to:

  • Identify & Time Entry/Exit points
  • Identify Support & Resistance
  • Strategic Stop Loss Orders
  • Identify Trends & Chart Patterns
  • Create Risk Parameters - Technical Indicators

All the above will aid the reduction of risk and help improve your chances of making profits.

Rules for Trading in a Volatile Market

1. Use Stop Losses

Using a stop loss – a present level at which an open trade is automatically closed – is standard good practice as this can limit your downside risk and also shows trading discipline which is paramount in developing a healthy trading account. However, when markets are incredibly volatile you could experience some slippage with the position not being able to be executed at the exact level specified.

2. Reduce Your Trade Size

Margin is one of the biggest advantages of CFD trading

A general rule of thumb is that no single trading position should amount to risk exposure of more than 5% of your available capital. However, in volatile market conditions, this kind of leverage is dangerous as any loses will magnify by even more than normal. The best market practice would be to halve your normal trading size over volatile trading conditions.

3: Limit Your Trades

Volatile markets are associated with high volumes of trading, which may cause delays in execution. While online trading normally means you place a trade at a current bid and offer you see, some market maker may widen bid-offer spreads or even temporarily withdraw tradable prices. This means that execution can be delayed and prices to execute it may not be available.

4: Stick to Your Strategy

During volatile times, it easy to be shaken and diverted from your normal trading strategy but most experienced traders apply the same strategy to choosing investments as they normally do. While it’s tempting to react to the volatility, it’s incredibly difficult to predict moves in the short term, so you have to stick to your trading strategies and limit your risk exposure when times are volatile.

Summery

  • We need Risk Management to control our losses
  • Always be sure to know your Risk Tolerance
  • Have a Risk Management strategy - Leverage/Volatility/Diversification/Asset Allocation
  • Incorporate a Stop Loss strategy as part of your Risk management strategy
  • Be disciplined in affecting your strategy
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