If you plan to trade, you are going to experience risk. In fact, the reason you can make money trading is that you are taking risks. Risk is the amount of money you could lose if you invest in an asset.
Risk is not the actual loss; it is the potential loss you might experience. There are many different types of risk including market risk, which can be defined as risks that arise from the movement of market prices.
Since the market pays you to take risks you cannot eliminate market-risk if you want to benefit from the movements in market prices.
Fortunately, there are several ways that you can mitigate market risk including hedging and diversification.
Types of Risks
When you invest, you expose yourself to many different types of risk. You could lose money on an investment for several reasons. Here are some of the risks you could face if you make an investment.
- Market risk is the risk that market prices will move against you generating a loss.
- Credit risk is the risk of default.
- Operational risk is the risk that the management of the company will not be able to execute.
- Systemic risk involves the decline of the entire market system.
- Liquidity risk describes your ability to enter and exit positions.
Credit risk is the potential loss due to non-payment or default. This is also referred to as counterparty risk.
For example, you agree to sell your house, but the buyers don’t pay. Credit risk was largely ignored by the global trading community until the financial crisis that began in 2008.
Credit risk ballooned as US banks owned millions of offsetting transactions with hundreds of counterparties. The bankruptcy of Lehman Brother created a domino effect that nearly crippled the global banking system.
Operational risk is the potential loss due to deficient processes or systems.
For example, a data breach could expose a company to millions in liabilities. Generally, operational risk occurs when new variables are introduced, such as the implementation of new software.
Systemic risk occurs when an event induces the possibility of a complete breakdown of the financial system. For example, the events that followed the 911 attacks could be categorized as systemic risks.
Liquidity Risk is the inability to buy or sell investments for a price that tracks the true underlying value of the asset due to volatility.
This could occur ahead of the release of new information. For example, ahead of a monetary policy decision market making traders might widen their bid/offer spread to avoid taking on new risk.
How Do you Manage Risk?
You cannot eliminate risk and still enjoy the rewards of trading riskier assets.
If you want to completely avoid risk, you can keep your money in cash or invest in a US treasury bill, where you have the full faith and credit of the United States government.
Since market risk is the risk you will face most often when you are trading, it’s helpful to understand some of the ways you can mitigate this type of risk.
Since you are paid to take risks, you want to determine how much you are willing to risk to achieve your desired reward. This might seem intuitive, but the ratio of how much you can win relative to the risk you will assume should drive your trading strategy.
Here is some math.
If you win more than you lose, on 9-trades the amount you win can be equal to the amount you lose to create a successful strategy. For example
- 5-winning trades earning $100 on each trade = $500
- 4-losing trades with losses of -$100 on each trade = -$400
- Net Profit of $100 (5*$100 – 4*$100).
Alternatively, if you lose more than you win on 9-trades, your winning trades will need to generate more than your unsuccessful trades. For example
5-losing trades losing -$100 on each trade = -$500
4-winning trades gaining $130 on each trade = $520
Net profit of $20 (4*$130 – 5*$100)
Creating a Risk Reward Ratio
The math behind a risk management strategy can help you create a risk to reward ratio. This is simply how much you plan to make on your trades relative to the amount you plan to risk. So, if you plan to make $3 for every $1 you risk, then your reward to risk is 3 to 1.
Alternatively, if you plan to risk $3 to make $1, than your reward to risk is $1 to $3.
How Do You Implement Your Risk to Reward Strategy?
It’s important to understand that you have control over your risk. Market risks can be minimized by implementing a stop loss strategy on each trade mitigating additional losses.
There are several ways to implement a stop loss strategy. You can use:
- Dollar loss
- Percent loss
- Support or Resistance
A dollar loss is an amount you are willing to lose on a trade. This figure should then be used to determine your reward to risk strategy.
A percent loss is based on the movement of the underlying asset you are trading in percent terms. For example, your stop loss could be after the SPY ETF declines more than 2%.
You can also use support and resistance to find a stop loss level. Support and resistance can be a horizontal trend line, an upward or downward sloping trend line or even moving averages.
Alternatively, you might have purchased the SPY in mid-October when the 10-day moving average crossed above the 50-day moving average with a stop loss at the 50-day moving average.
Your stop loss should also extend to your trading strategies. When you allocate capital to a strategy, you should consider in advance how much in aggregate you are willing to lose before you pull the plug on this methodology.
Using Diversification to Mitigate Risk
There are several benefits to using a stop loss strategy to mitigate your risk. Another technique is using diversification and asset allocation. The concepts are based on the notion that you should not put all your eggs in one basket.
If you plan to trade, its helpful to have multiple trading strategies that focus on several different assets. If you use all your money to trade stocks, and your only strategy is buy-and-hold, then you could experience the risk of ruin if there is an adverse market price change.
Those who used this strategy in 2008-2009 could have lost 50% of their capital or more.
Asset allocation is the process of splitting your money into different investment endeavors. This could include stock trading, real-estate investing, and buying a business. Diversification pertains to the different assets that you trade within a portfolio.
For example, you might consider trading stocks, bonds, commodities and indices, as well as using a long-term and short-term trading strategy to generate profits.
So, if a situation arises where you lose money on your short-term commodity strategy, but the losses are more than offset by your short-term stock strategy and your long-term stock strategy, then you could have a profitable portfolio.
The key takeaway is that market risk is inherent in trading. You make money because there is market price risk. To prudently trade the capital markets its helpful if you understand risk and ways to manage risk.
Risk is defined as the amount of capital you could lose when trading. Risk management is how to handle investment risks.
Prior to entering any transaction or allocating capital to a portfolio, you should create a risk management plan that incorporates the risks you plan to assume. Its very helpful if you determine a risk to reward ratio which will define your trading strategy.
Essentially, traders create risk management plans to protect their funds. You can define a risk management plan for an aggregate of trades or each trade, individually. Your trading strategy should incorporate your risk as well as your financial goals.
You can use a stop loss strategy to help you develop a risk management plan for individual trades. This can be a dollar figure, a percent loss or a specific chart point. In addition to having a stop loss for each trade, you should have a stop loss on your strategy.
You should also use a combination asset allocation and diversification to manage your risk. This includes using multiple trading strategies to trade multiple assets. This will mitigate any risks that occur with one specific asset or strategy.
There are also several other risks inherent in trading. There are credit risk, operational risk, systemic risks and liquidity risk.
You should have a clear understanding of each of these risks, as well as market risk before you begin to trade.