Basics of Risk Management
Assessing and reacting to risks is an essential part of managing risks throughout our lives. Risk management is necessary for simple tasks like driving a car and making insurance or medical plans. Most of us manage risks unconsciously during everyday activities. However, in financial markets and business administration, assessing risks is a conscious practice.
In economics, risk management is a framework that defines how a company or investor handles financial risks inherent to all businesses. The framework for traders and investors may include managing multiple asset classes such as cryptocurrencies, Forex, commodities, shares, indices, and real estate.
Financial risks come in many types and can be classified in various ways. This article provides an overview of the risk management process and presents some strategies that traders and investors can use to mitigate financial risks.
How Does Risk Management Functionate?
The process of risk management typically involves five steps: setting objectives, identifying risks, risk assessment, defining responses, and monitoring. However, the steps may vary depending on the context.
- Set objectives involve defining the main goals and the level of risk tolerance.
- Identifying risks by detecting and defining potential negative events. This step may also provide insightful information beyond financial risks.
- The risk assessment involves evaluating the frequency and severity of identified risks and ranking them in order of importance.
- Defining responses involves establishing appropriate actions to be taken for each type of risk based on their level of importance.
- Monitoring the effectiveness of the risk management strategy in response to events often requires continuous data collection and analysis.
Financial Risk Management
A successful trade setup can fail for various reasons. For instance, the market may move against a trader's position, or the trader may get emotional and sell out of panic. Emotional reactions often lead traders to abandon their initial strategy, especially during bear markets or periods of capitulation.
Having a proper risk management strategy is crucial to succeed in financial markets. A simple risk management strategy could be setting Stop-Loss or Take-Profit orders. A robust trading strategy should provide a clear set of possible actions, enabling traders to deal with different situations. It is essential to revise and adapt these strategies continuously.
There are many ways to manage risks. Here are a few examples of financial risks and how to mitigate them:
- Market risk: minimize by setting Stop-Loss orders on each trade to automatically close positions before incurring significant losses.
- Liquidity risk: mitigate by trading on high-volume markets. Assets with a high market capitalization value tend to be more liquid.
- Credit risk: reduce by trading through a trustworthy exchange so that borrowers and lenders (or buyers and sellers) don't need to trust each other.
- Operational risk: mitigate by diversifying portfolios to prevent exposure to a single project or company. Researching companies less likely to experience operational malfunctions can also help.
- Systemic risk: reduce by diversifying portfolios involving projects with distinct proposals or companies from different industries, preferably with low correlation.
Effective Strategies for Managing Risks
Traders and investors usually employ various risk management tools and strategies to enhance their portfolio growth since there isn't a specific method to address risk management. The following are some strategies utilized by traders to reduce risks.
The 1% Trading Rule
Traders who adopt the 1% trading rule limit their losses to a maximum of 1% of their trading capital per trade. They can trade either with 1% of their portfolio per trade or with a bigger order with a stop-loss that is equal to 1% of their portfolio value. Day traders usually use this rule, but swing traders can also adopt it.
However, some traders adjust the 1% value to account for factors such as account size and risk appetite. For example, traders who have larger accounts and are more conservative may choose to restrict their risk per trade to a smaller percentage than 1%.
Stop-Loss and Take-Profit Orders
Traders can use stop-loss orders to limit potential losses in case of a negative trade outcome and take-profit orders to secure profits if the trade goes well. To ensure efficient execution, these orders should be placed immediately after entering a position and with predetermined price levels.
In a highly unpredictable market environment, it is crucial to know when to cut losses to prevent further harm. By planning an exit strategy, traders can avoid making hasty decisions based on emotions. Determining stop-loss and take-profit levels is also crucial for calculating the risk-reward ratio of each trade.
Hedging is a strategy employed by investors and traders to lessen financial risk. The idea behind it is to take two opposing positions that can offset each other. Essentially, one trade can be hedged by entering an opposing trade of equal or similar size. Despite sounding counterintuitive, hedging can minimize the impact of a market move if done correctly.
For example, suppose an investor is long on BTC and holds it in a personal wallet. In a downtrend, a short position can be taken to counteract the long position without transferring BTC, creating a market-neutral strategy.
To mitigate financial risk, investors often diversify their portfolios by investing in multiple assets rather than just one. The idea behind diversification is not to put all your eggs in one basket. If an investor has a well-diversified portfolio, it offers more protection against massive losses compared to a portfolio made up of only one single asset. For instance, if a crypto asset is held in a diversified portfolio and its price tumbles, the maximum damage it could cause would be a percentage of the portfolio. In contrast, if the portfolio is entirely made up of a single asset, it could result in a loss of 100% of the portfolio's value.
Calculating the risk-reward ratio is a way to measure the potential risk a trader is willing to take compared to the potential reward. You can determine this ratio by dividing the potential loss by the potential profit of a trade. For example, if your stop-loss is set at 5% and your target profit is 15%, your risk-reward ratio would be 1:3. This means that your potential profit is three times greater than your potential loss.
Developing a risk management plan is crucial for traders and investors before entering a trading position or allocating capital to a portfolio. However, it is important to understand that financial risks cannot be completely eliminated.
Risk management is not just about avoiding risks altogether but also involves strategic thinking to handle unavoidable risks most effectively. This involves identifying, assessing, and monitoring risks within the context of the strategy being used.
Risk management aims to evaluate the risk-to-reward ratio so that the most profitable positions can be prioritized. Overall, risk management involves a process of assessing and balancing the potential risks and rewards of each trade to make informed and effective decisions.