Every type of investment involves certain risks. In trading, risk is defined as the potential failure of an investment to deliver the anticipated return.
That could mean getting lower profits than expected, losing all the original investment, and in some cases losing more than the original investment.
A risk is simply the measure of the level of uncertainty to achieve an investor’s expectations in terms of returns.
Some experts believe that there is an appropriate level of risk. But it is often difficult to distinguish between thoughtless risk and prudent risk. Traders who are too risk-averse will not be able to hold on to an investment long enough to realize potential profits. On the other hand, traders who risk too much may end up taking huge drawdowns which can have negative psychological effects.
But with sufficient experience, traders can learn to balance their trading risk and tolerate its uncertain nature. They can also learn to trade in the “zone” without dwelling too much on their emotions or past mistakes.
Different Types of Risks
There are several types of risks that traders face and need to manage to ensure profitability. There are three general categories of risks: market risks, investment risks, and trading risks.
Market risks are out of the traders’ control. These are often caused by movements in stock prices, interest rates, foreign exchange rates, and commodity prices. There are three subcategories of market risks including inflation risk, marketability risk, and currency translation risk.
Investment risks are related to how traders make investments and manage their entry and exit trades. This category of risks includes opportunity and concentration risks.
Opportunity risks involve balancing trade-offs. This type of risk simply means missing investment opportunities while the money is tied up in another investment.
Concentration risks involve investing too much money on one investment.
Trading risks are uniquely associated with trading. Risks associated with trading include slippage risk, poor execution risk, and gap risk.
Slippage risk involves hidden costs associated with every transaction. Poor execution risk occurs when the trader or the broker encounters problems in making the trade or the investment. Gap risk arises when there is a break in trading.
Risk Management Strategies
Seasoned traders implement risk management strategies to protect trading profits and to prevent losses from getting out of control. Risk management involves identifying, analyzing, and reducing risks in trading decisions.
Without an effective risk management strategy, a trader can lose all profits and even the entire investment in just one or two bad trades.
Here are several risk management techniques used by active traders.
- Planning the trade – Planning can often spell the difference between success and failure. This strategy involves setting stop-loss and take-profit points and determining your course of action ahead of time.
- Understanding the risk in each market – Trades need to understand the factors that influence different markets to develop appropriate dealing or investment strategies.
- Assessing risk/reward or risk-return ratio – This involves weighing a trade’s risk against its potential return. A trade with higher risks usually has higher returns. As an example, government bonds are low-risk investments but offer lower returns compared to corporate bonds. The higher risks in corporate bonds are compensated by higher returns.
- Using the one percent rule – This means never investing more than one percent of the capital or trading account into a single trade. It is common for traders who have accounts of less than $100,000. Those with higher balances usually choose to go with a lower percentage.
- Calculating expected return – It is important to have a systematic way to compare different trades and choose the most profitable ones compared to the risk taken. Expected return can be calculated using this formula: [(Probability of Gain) x (Take Profit % Gain)] + [(Probability of Loss) x (Stop-Loss % Loss)]
- Setting take-profits and stop-loss points – These can help traders protect profits and minimize losses. A take-profit point is the price at which a trade can make a profit from selling a stock. On the other hand, a stop-loss point is the price at which a trade will incur a loss from selling a stock.
- Buying downside put options – A protective put or married put can help traders control losses from a trade. It gives traders the right, but not the obligation, to sell the underlying stock at a specified price. Essentially, it offers a hedge on the investment and downside protection.
- Diversifying and hedging – Traders should never put all their eggs in one basket. Diversifying investments across industry sectors, geographic region, and market capitalization will not only reduce risks but also open up more opportunities. They should also consider hedging their position when the results are due and then unwinding the hedge when the trading activity subsides.
On the last point, legendary investor Ray Dalio made an interesting video that breaks down how diversifying in uncorrelated assets can significantly cut down your risk.
Trading can be a profitable venture. But traders must understand trading risks and implement the appropriate risk management techniques to avoid or minimize losses and ensure profitability.
They must also learn to trade successfully while managing risks. One way to do this is to keep track of which trades and strategies have worked. Traders should learn from their failures and build on their successes.