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Introduction to risk management

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

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.

FAQs

What are the best strategies for risk management?

Risk management practice should influence all of your trading, from selecting which market to trade, what positions to take and of what size, and market timing. If the VIX is up, expect greater volatility to come and adjust your stop loss to protect your trades. If a market is stable with little volatility, consider using leverage to maximise your potential gains from the flat market. The most important risk management factors to consider are stop losses and the risk reward ratio, and volatility measures such as VaR and risk. No matter how thorough your risk management protocol, traders do need to remember that their capital is at risk when trading on live markets.

That said, the best strategy for risk management in trading will be different for everyone, as every trader has their own goals and acceptable risk tolerance level. You can find out more about volatility measures and risk management factors in our learning section.

How do I calculate market volatility?

The formula for calculating volatility is the standard deviation multiplied by the square root of the number of periods of time. To collect this data, you need to find the average and standard deviation for the asset over a time period, and then multiply it by the square root of the number of periods. The standard deviation shows how far real price moves deviate from the mean, and both a higher standard deviation and higher volatility figure indicate a more turbulent market.

What is the VaR calculation?

To calculate value at risk you can choose between three different methods. The first, the historical method, involves taking real price data for a time period and working out the distribution of daily returns, which you then plot on a histogram. You can then find the real figures for the worst 5% or 1% of days in that return. The easier but less accurate method is to assume a normal distribution of returns and plot this curve against the real results.

Finally, advanced analysts may use a Monte Carlo simulation to produce a plausible set of fake returns and estimate the standard deviation from there. The most important decision is the confidence level, which is normally either 95% or 99%. For a 95% confidence limit, find the loss at the left end of the distribution curve, where the 5% percentile falls. For 99% do the same with the first percentile. This will give you the expected loss in the worst 1% of sessions or 5%, depending on the level you choose.

What are some common ways to manage risk when trading?

When trading the financial markets, setting stop-losses, guaranteed stops, and limit orders when you open your trade are all good ways to protect your capital should the markets move against you unexpectedly. Setting stop-losses can allow you to close out your positions automatically when the asset price crosses a certain level, while guaranteed stops can do the same when the asset price reaches a specific number. With a limit entry or closing order, you can enter or exit the market at a predetermined level that is more favourable than the current market price.

Other ways traders manage their risk include setting up price alerts within the platform on which you are trading, and opening trading accounts with negative balance protection which ensures their account balance never dips below zero. Negative balance protection is available at ADSS for non-professional traders, and you can learn more about how ADSS approaches risk in our Risk Warning guide.

What is ‘gapping’ in trading?

In trading, ‘gapping’ refers to an instrument price moving suddenly from one level to another, resulting in a gap that can have a direct impact on your open positions. Gapping occurs when market volatility is high and price fluctuations are rapid, and it may be caused by a number of reasons, such as economic data releases, natural disasters, or major global political events. Gapping happens when markets are closed. This means that the opening price of a trading instrument may be vastly different from its previous closing price, which can have a direct impact on your potential profits and losses. To minimise the potential negative effects of gapping, traders can use a disciplined set of entry and exit rules on their trades, such as stop-loss and limit orders.


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Investing in CFDs involves a high degree of risk that you will lose your money due to the use of leverage, particularly in fast moving markets, where a relatively small movement in the price can lead to a proportionately larger movement in the value of your investment. This can result in loses that exceed the funds in your account. You should consider whether you understand how CFDs work and you should seek independent advice if necessary.

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