According to the Merriam-Webster dictionary, “risk” is defined as “the chance that an investment will lose value” in financial situations.
It’s often said that trading the financial markets is effectively the trading of risk – with the possibility of losing all of your initial investment. However, risk also equates to opportunity. With almost no exceptions, the higher the risk, the higher the potential reward. Conversely, the lower the risk, the lower the potential reward. This is known as the risk/reward trade-off.
For example, buying US Treasury bonds – one of the safest investments one can make – can yield roughly 1.2% in interest payments, which does not even cover a 3% inflation rate. On the other hand, putting your money into highly volatile cryptocurrencies might result in a 20% return or loss in a week.
However, risk levels are not static. There are ways to lower risk during trading. This is done by understanding the markets and making informed decisions, as well as using risk-management tools to minimise potential losses.
What is Risk Tolerance?
As mentioned, potential rewards grow with the risk level. However, not everyone is suited to trading in a high-risk environment. Every trader has their a different temperament and circumstance, and your trading style will often define how low or high risk your strategy is.
Your Risk Tolerance is the degree of uncertainty that you can handle regarding a potential loss.
Risk tolerance will be different for each person, and how much you can handle generally depends on three things.
Income – Your income and personal situation. A person on a low salary about to get married will likely have a lower risk appetite compared to 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 lower risk compared to shorter time horizons.
Investment Objectives – The more ambitious your financial goals, the greater risk you will have to take on.
Stop-loss and Take-profit Orders
Stop-loss Orders are the single most important risk management tool and should always be employed when trading. They are limit orders that allow traders to minimise losses and maximise profit. The following are some of the types:
Breakeven Stops: executed at the point at which gains equal losses
Time Stops: waits for a predetermined period before the order is executed
Trailing Stops: trailing stops continuously update as long as the price moves favourably, only closing when the price moves away from a set at a percentage or flat amount away from the market price.
Asset allocation is an investment strategy aimed to balance risk and reward. allocates a portfolio’s assets according to 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 mitigates risk by distributing your assets among various investment categories. Diversification is particularly helpful when trying to offset unsystematic risk, which is the risk that is specific to a company or industry.
Diversification is based on the rationale that certain assets are inversely correlated, or have no correlation at all. Therefore, bad performers should be offset by the good ones. The lower the correlation between the investments in your portfolio, the lower the risk. Such correlations include:
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 can amplify the size of your position, but also increase your risk level. Leverage can be tailored according to your risk appetite. If you are risk-averse, trading on higher margin requirements will decrease your risk level. Treat leverage as a credit card, and never spend more than you can afford to lose.
Technical analysis can serve as a powerful tool in risk management
We can use it to:
All the above will aid the reduction of risk and help improve your chances of making profits. For detailed information on this topic, visit our technical analysis module.