Introduction to risk management

Introduction

Financial markets are systems for allocating risk. This is true regardless of the asset being traded: in credit markets, bondholders are rewarded for taking on the credit risk of a business or government; in stocks the business risk of the company and market risk of the stock are taken on by shareholders; in forex, traders earn a return by taking on the market risk of a currency. Without risk, it is impossible to potentially make money in the markets, except for very rare arbitrage opportunities. Traders can profit from price movements – volatility – and they exploit these moves to take out positions.

Risks come in a few different types, the most important being credit and market risk. Whenever a trader is exposed to risk, they need a strategy for managing this exposure and protecting themselves from losses. However, since risk is closely tied up to return, it isn’t something traders should shy away from. Knowing which risks to take on and how to do so intelligently is a key part of success in the forex market. Before you can use risk management to guide your trading, it is important to understand some basics, starting with a good definition of risk and ways to measure it.

What is risk?

When traders discuss risk, they are normally talking about market risk – the impact of volatility on your portfolio. Market risk refers to any negative effect of volatility on your assets, in other words, the risk of losing money due to unfavourable price movements. But what is volatility? A simple concept, volatility is just variability of price; if an asset’s price frequently makes large moves, it is volatile. Volatility treats up and down moves the same: an asset may be volatile because of sudden price increases as well as falls. This makes sense for CFD traders, who take both long and short views on the underlying market.

Not all assets are equally volatile. Across asset classes, stocks and commodities tend to be more volatile than forex and bonds, and within currency markets, emerging markets and exotic pairs are more volatile than reserve currencies like the US dollar. Traders seeking fast-paced, volatile markets may want to consider trading CFDs on commodities while traders interested in less variable markets should look into forex CFDs.

Remember that volatility varies over time, and it tends to increase across all markets during periods of stress. Long periods of stable markets can be interrupted by sudden outbursts of volatility, so do not grow complacent even during quiet sessions. Since market risk can directly affect your potential for losses, it is the most important type of risk faced by traders. Market risk is higher in volatile markets, such as currencies or stocks from emerging markets, and when trading with leverage where positions sizes are magnified. Good trading risk management involves limiting leverage in volatile markets, or for larger positions.

Other types of risk in trading

Market risk is not the only type of risk facing traders. Credit risk is another important type that particularly impacts bond traders. For equity, forex, and CFD traders, credit risk is less important, although defaulting government bonds can also influence FX rates.

Put simply, credit risk is the danger that a borrower might not repay their debts. If you hold a debt instrument, there is a chance that the borrower will not pay back the principle or any coupons owed due to bankruptcy. Because credit risk increases with less trustworthy borrowers, credit ratings are an important tool for banks and lenders to identify riskier debts, and to increase return or even refuse to lend accordingly.

How do we measure risk?

Market risk, the impact of price moves on returns, can be tough to measure because it changes according to conditions and the asset traded. For example, a short CFD position has a theoretically unlimited risk as the underlying increases in price, while a long one can only ever fall to zero. Risk is also influenced by how much you stand to lose – an investment involving 100% of your portfolio is inherently riskier than one with only 1%, even if the asset is less volatile.

To deal with these problems, some market analysts use Value at Risk (VaR) to measure market risk instead of volatility. VaR expresses risk as the maximum likely loss within a fixed time period for a 95 or 99% confidence limit. A higher VaR indicates greater exposure to market risk. VaR is frequently used in investment managers and by market analysts to determine safe exposure levels.

When you first start to develop strategies for risk management in trading, you do not need to worry too much about technical measures such as VaR, but one immediately useful tool is the VIX, popularly known as the volatility index or ‘the fear index’. The VIX gives an indication of negative market sentiment and expected future volatility, with spikes giving warning of troubled markets ahead. Traders wondering how to measure market volatility can look at the VIX and get a visual representation of volatility. This can then be used to time trades and guide position sizing.

How do we manage risk?

Risk management offers traders guidance on how much to risk per trade, with more capital risked on less volatile markets and more stringent risk management practices in volatile and uncertain ones. Traders can check headline volatility measures like the VIX and use them to time positions.

Proper risk management also influences how we trade. Good risk management practice protects the risk / reward ratio of a trade, placing stop losses at 50% of the take profit distance from the initial price. For example, if you take out a CFD on a stock at $100 with a take profit of $110, putting your stop loss at $105 preserves the ideal 2:1 risk / reward ratio. This prevents you from taking on undue risks in order to make small gains.

Risk management in trading isn’t about avoiding risk, since in short-term trading taking on risk is an important part of any successful strategy. Volatility moves markets up and down, and CFD traders take both long and short positions, so you shouldn’t be afraid of volatile markets. In fact, it can be harder to make a profit during calm, stable market conditions. Even so, while a certain level of volatility is important for successful trading, volatile markets are often dangerous ones.

Fortunately, there are things you can do to help. Managing your exposure in the case of adverse market movements starts with position sizing. Traders should split their portfolio across multiple small trades, not concentrating it across a few positions.

How to break up your portfolio depends on the overall size – for a $10,000 portfolio 1% position sizing may be too small to trade effectively (without leverage), whereas for a $100,000 one 1% is an ideal trade size. Concentration is more acceptable in very small portfolios, but it is still important to avoid over-concentrating your risk in a few trades, especially if those positions are correlated. Maintaining a sensible forex position size alongside rigorous use of stop losses will protect you from volatility while preserving your overall returns.

Risk and correlation

One important factor to remember when managing your risk is correlation. Holding multiple smaller positions make sense for traders because of the principle of diversification – if you have many different assets, it is less likely they will all lose value at once. But this is not true 100% of the time, and the reason for that is correlation.

What is correlation?

Correlation is a number, usually between -1 and 1, that tells you how closely related two assets are. If Stock A and Stock B have a correlation of 1, for each $1 in value gained by Stock A, Stock B will also gain a dollar. If the correlation is 0.5, it would gain $0.50 for each $1 gain by A. Correlations can be negative – Stock B loses when Stock A gains, or greater than 1, where moves in A are magnified in B. Correlation is not stable and changes over time, with the behaviour of correlated assets changing considerably during periods of market stress.

Correlation in the financial markets

Many traders have noticed that when stocks lose value, many different equities tend to drop at the same time. That is because most equities are correlated, so losses are felt across the market. For forex traders the situation is very different, since every FX trade involves both a base and quote currency. In the FX market, exotic and emerging markets currencies tend to be negatively correlated with major pairs and reserve currencies, which are seen as safe haven assets. Correlation also makes itself felt across asset classes, with riskier currencies and poorly rated debt positively correlated with growth equities, while government bonds and safe haven currencies correlate negatively with the volatile, ‘risk on’ parts of the stock market.

Traders need to know about correlation because they need to avoid too much of it in their portfolio. After all, there is no point diversifying if all your stocks will move down together because they are impacted similarly by the same events. Fortunately, ADSS CFD traders can diversify within the same market by taking out both long and short positions with ease. Traders should take different positions in order to protect from overall market downturns, while being aware of how the underlying assets that they are trading are correlated.

Summary: why we take on risk

Traders need risk to make a profit in the financial markets. Without volatility, markets would never move, there would be stable or no trends, no overreactions, and no corrections. This would not be an ideal situation for traders, who strive to make a profit from taking advantage of price fluctuations. Market risk is necessary for anyone to make a profit in the market. On the other hand, taking on risk blindly can lead to losses. Traders have lots of methods to better protect themselves from market volatility, such as utilising the VIX, position sizing, and more. Understanding these risk management strategies better will lead you to make wiser decisions and to become a better trader.

Disclaimer: Risk can never be eliminated from trading and investment activity. Even with sound risk management strategies in place, the financial markets can move in unpredictable ways that lead to monetary losses.

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