5. Risk

Let's not get ahead of ourselves; before speaking about how to manage our risk, let’s make sure we understand what "risk" actually means.

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 minimise 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 LeverageHigh 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 LeverageLow 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 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. In volatile markets there is often a “gap”, where a product moves substantially lower or higher than expected perhaps as much as 10-15%. With a normal stop loss you will get the first available price which could cause a large loss and result in a loss greater than your initial deposit.

2. Reduce Your Trade Size

Margin is one of the biggest advantages of CFD trading and at One Financial Markets our 0.25% on FX and spot gold, 0.20% on major Indices and 3% commodities is among the most competitive in the market place however with any margin trading you should always be aware of how much is required to keep your position in the market.

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 magnified 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 at may not be available. One Financial provides fixed spreads no matter what market conditions but in times of increased volatility it is sometime better to limit trade execution.

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.

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

Begin trading today! Create an account by completing our form

Contracts for Difference (CFDs) and margined FX are leveraged products which carry a high degree of risk to your capital. Prices may move rapidly against you and may result in you losing more than your initial deposit. CFDs and FX may not be suitable for all investors and you should fully understand the risks involved before opening an account. Please read the Risk Warning Notice on our website.

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