Financial Risk
Risk in any situation is Uncertainty
‘The chance of an outcome being different than expected’
So now that we know what risk is, what exactly is risk in terms of finance?
‘The chance of an investment’s actual return being different than expected’
It’s often said that trading the financial markets is effectively the trading of risk.
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
Why “risk” it?
If trading the financial markets is effectively the trading of risk, then why would we “risk” the market going 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
What makes trading such risky business?
There are lots of things which influence what type and how much risk is experienced.
1. Leverage
‘Leveraging lets you magnify your profit potential, at the risk of greater losses, through allowing you to control a relatively large asset for a fraction of its cost’
0.25% margin deposit means you are trading 400 times leverage, for example;
Buying 1 lot of GBP/USD @ 1.5700 with a margin requirement of 0.25% will cost you $250.
The margin requirement means that you can trade a volume of $100,000 in the market.
Through leveraged trading you can take advantage of very small movements in the market by trading very large volumes
Higher leverage = More risk = Larger profit potential<>
2. Volatility
‘Volatility can be described as the size of changes in an assets value (price movement) over time’
Volatility measures the dispersion of price values. High volatility means price can swing dramatically in either direction over a short period of time.
Higher volatility = More risk = Larger profit potential
3. Trading Psychology
The final factor that affects risk is trading psychology – this will be covered in the module that follows.
Although it does not seem it in nature, trading is in fact very emotional and emotions often affect and influence trading decisions.
Fear and Greed; generates greater implied volatility – do not let your emotions get the better of you
Hope (‘false dawn’); often leads to greater risk as it causes us to hold onto losing investments when we should be cutting our losses.
Bad Mental State; For whatever reason, whether you have just incurred losses or are fatigued – do not make investment/trading decisions
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
Breakeven Stops – executed at the point at which gains equal losses
Time Stops – it relies on a certain period of time elapsing before the order is executed
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.
Learn to love your losses, manage your losses, and learn from your losses, or one day you will have the mother of all loses that will wipe out your entire account
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/trading strategies are of little help if you do not control risk
How tough are you?
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 medium 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 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.
The lower the correlation between investments in your portfolio, the lower the risk
Example of Correlation;
Gold and the US Dollar
Gold is inversely correlated to the dollar meaning that the value of gold appreciates as the dollar weakens
Gold and Crude Oil
Rising crude oil prices tend to lead to a rise in the value of gold as gold is often bought as a hedge against inflation
Controlling Your Leverage
Leverage Scale: | – | – | – | Risk Level |
0.5% | Margin Requirement | = | x200 Leverage | High Risk |
1% | Margin Requirement | = | x100 Leverage |
|
3% | Margin Requirement | = | x33.3 Leverage |
|
10% | Margin Requirement | = | x10 Leverage |
|
20% | Margin Requirement | = | x5 Leverage |
|
50% | Margin Requirement | = | x2 Leverage |
|
100% | Margin Requirement | = | No Leverage | Low Risk |
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
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.
For more information on Technical Analysis please see the “Analysis” Module
Golden rules for trading in a volatile market
1. Use Stop Losses
Using a stop loss – a current level at which an open trade is automatically stopped – is common good practise since it reduces your downside risk and demonstrates trading discipline, both of which are essential in building a healthy trading account. When markets are extremely volatile, however, slippage may occur, resulting in the position not being executed at the exact level requested. There is typically a “gap” in turbulent markets, where a product goes much lower or higher than predicted, perhaps as much as 10-15%. With a standard stop loss, you’ll get the first available price, which could result in a big loss that exceeds your initial deposit.
2. Reduce Your Trade Size
Margin is one of the most attractive aspects of CFD trading, and One Financial Markets’ 0.25 percent on FX and spot gold, 0.20 percent on major indices, and 3% on commodities is among the most competitive in the industry. However, when trading on margin, you should always be aware of the amount required to maintain your position in the market.
A good rule of thumb is that no single trading position should expose you to more than 5% of your available capital in danger. In turbulent market conditions, however, this type of leverage is risky because any losses will be magnified considerably more than usual.
Over volatile trading situations, the best market practice is to halve your typical trade size.
3: Limit Your Trades
High volumes of trade are connected with volatile markets, which can create execution delays. While online trading usually entails placing a trade at the current bid and offer, some market makers may temporarily widen bid-offer spreads or even remove tradable prices. This means that execution may be delayed and that the prices at which to execute may be unavailable. Regardless of market conditions, One Financial offers fixed spreads, however it is sometimes preferable to limit transaction execution during periods of greater volatility.
4: Stick to Your Strategy
It’s easy to get shaken and diverted from your typical trading technique during volatile periods, but most skilled traders use the same strategy for selecting investments as they do for trading. While it may be tempting to react to market volatility, it is extremely difficult to foresee short-term movements, therefore you must stick to your trading techniques and reduce your risk exposure when the market is volatile.
What are the important bits?
- 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 effecting your strategy
PLAN YOUR WORK AND WORK YOUR PLAN
