How to Manage Risk as a Trader or Investor
Key Takeaways:
- Risk management in trading will protect your account and help you grow your funds
- Good risk management means having a trading strategy and following a set of rules
What Does it Mean to Manage Risk in Financial Markets?
Risk management in the financial markets is a technique aimed to protect your account from losses. More specifically, risk management refers to all strategies you use to identify and evaluate risks in trading and investing.
Managing risk should go together with any trade you open so you would make sure all of your positions are under control. In other words, you guarantee no single position could wipe out significant amounts of money from your account.
Moreover, by using proper risk management, you take away uncertainty from trading and ensure your trading account is stable and healthy.
Why is Risk Management Important in Trading?
In trading and investing, the way you handle risks will mean whether you win or lose. That’s why risk management is crucial when you set out for your trading endeavors. Not only does risk management evaluate the downside in any trade, but it also aims to catch the most upside possible.
Put simply, risk management minimizes losses and maximizes profits. As a trader or investor, you will be faced with multiple opportunities to enter the market every single day. Thanks to risk management, you can be certain your account will endure even the worst storm.
And because the global financial markets are complex and involve countless factors at play, there will be lots of financial storms.
Ways to Identify Risks Across Markets and Manage Them
Every market has its own intrinsic risks that you need to be aware of. And at some points, you may find yourself micromanaging risks related to a specific stock. At other times, you may be assessing risks over a whole economy, especially if you’re looking to trade currencies.
With this in mind, your job as a trader or investor is to make sure you have taken risk into consideration before you’ve entered the market.
In order to do that, look at the wider market and distinguish different financial assets and asset classes.
What are some examples of risks in the most popular markets?
Essentially, your choices narrow down to the following markets:
- Stocks
- Forex
- Indices
- Commodities
- Cryptocurrencies
Each one of these markets, or asset classes, has specific risks. Stocks, for example, get pressured by disappointing earnings reports. Forex pairs may be knocked by unfavorable geopolitical developments. Indices are likely to get swayed by economic uncertainty and Federal Reserve decisions.
Commodities such as gold and oil could see sudden drops if investors pivot quickly to more fashionable assets like stocks. And cryptocurrencies, as the newest wonder of technology, are famous for their daily volatility and aggressive swings.
How to Protect Your Portfolio From Outsized Risks
The way to protect your portfolio from outsized risks is to design a clear and robust trading strategy. A solid trading strategy, on this note, will help you stick to a plan, or a set of rules, that will help you get the most profit with the least amount of risk.
Ideally, your trading strategy should be tailor-made to fit your trading style, risk tolerance, and overall approach to markets. You can, of course, seek traditional trading strategies which would likely say you need to diversify and never risk more than 2% on any given trade.
So, what’s an outsized risk? This is the number of funds that you have not planned to lose. In other words, losing more than you have intended. In turn, this could make coming back to your starting point increasingly more difficult.
Risk Management Strategies Using Leverage
Getting into the markets as a retail trader or investor assumes you are using leverage in order to magnify your potential profits. And if you’re not aware how leverage works, it could put serious dents into your trading account.
Once you step into the financial markets, you will see hundreds of quotes, flashing in green and red. The allure of the trading platform could be a double-edged sword. In reality, the easiest thing would be to go ahead and start trading, opening positions across assets.
While easy, this could cost you your funds unless you base your actions on strong convictions and strategies.
For example, a leverage of 100:1 would mean you control 100 times more than your capital. More specifically, $1 invested will be worth $100. Therefore, it’s important to approach any trade with caution and keep in mind that the power of leverage goes both ways. It could maximize your profits but it could also work in reverse and eat into your account.
10 Rules of Proper Risk Management
When you use leverage and want to get into the markets, regardless of asset classes, it’s important to keep in mind the 10 rules of proper risk management.
- Never risk more than you can afford to lose;
- Go with a risk you’re comfortable taking;
- Design a trading plan and stick to it;
- Always use a stop-loss order to control the risk;
- Always use a take-profit order to secure gains;
- Never let a winner turn into a loser;
- Don’t trade out emotions;
- Avoid overtrading, only trade when you have conviction;
- Cut losses early;
- Let profits run;
How to Handle Risk as an Investor
Being an investor means you’re focused on long-term gains and plan to stay in the market for months or even years. In other words, you practice the so-called ‘buy-and-hold’ approach to the market. In this light, you need to follow a risk management strategy tailored to help your investments grow over time.
Diversification
Every investor needs to diversify properly in order to make the best out of market opportunities.
Hedging
With diversification comes hedging, which allows you to introduce flexibility to your portfolio. In other words, if one investment goes sour, another one will make up for it as it goes up.
Consistency
Careful analysis, planning, and consistent action are the way for an investor to stay in the game for as long as possible.
How to Handle Risk as a Trader
Being a trader assumes your risk is relatively short-term and you expect to reap profits in a matter of a few days. To this end, a trader should be using similar techniques to those of the investor, with a few additions.
Stop loss and take profit
The most important technique for every trader is stop-loss orders and take profits orders. A stop-loss guarantees your position will be closed automatically once it slips to a level you’ve set as a downside limit. And a take profit will close your position in profit and lock in the gains, automatically transferring them to your account.
Diversification
Having a few positions as a trader could be beneficial to your account. Having too many, on the other hand, could weigh on your perspective and lead to losses. Balance your positions so they won’t be too much of a hassle.
Hedging
This approach to the market is key when you want to find the perfect balance in your portfolio. You can hedge positions by going to currencies, gold, stocks, and even cryptocurrencies.
Manage Risks Like the Trading Legends
The truth of the matter is that every successful trader or investor has found what suits them and has banked on it.
Paul Tudor Jones on risk-taking
Paul Tudor Jones, a legendary trader, and a hedge fund manager says about risk:
- “Don’t be a hero. Don’t have an ego. Always question yourself and your ability.”
- “The most important rule of trading is to play great defense, not offense.”
- “When I trade, I don’t just use a price stop, I also use a time stop.”
- “When I am trading poorly, I keep reducing my position size.”
- “The most important thing is how good you are at risk control.”
Ray Dalio on risk-taking
Another trading giant, Ray Dalio, the founder of the world’s biggest hedge fund Bridgewater Associates, also puts tremendous focus on risks. Here’s what he says:
- “In trading, you have to be defensive and aggressive at the same time. If you are not aggressive, you are not going to make money, and if you are not defensive, you are not going to keep money.”
- “To make money in the markets, you have to think independently and be humble.”
- “I saw that to do exceptionally well you have to push your limits and that, if you push your limits, you will crash and it will hurt a lot. You will think you have failed—but that won’t be true unless you give up.”
- “Don’t mistake possibilities for probabilities. Anything is possible. It’s the probabilities that matter. Everything must be weighed in terms of its likelihood and prioritized.”
- “Most fundamental work principle: Make your passion and your work one and the same and do it with people you want to be with.”
Summary
Taking risks in trading and investing is mandatory if you want to progress and grow, both in financial terms and personally. To this end, make sure you realize the risks involved in trading and always use proper risk management strategies that will help you accelerate to higher grounds in the world of trading and investing.
