Introduction to Risk Management in Trading

7 min read

By Chainika Thakar

Risk management is one of the most important aspects of trading, where a trader needs to have a good knowledge of risk identification, evaluation and management. This article covers the following aspects of risk management:

What is Risk Management in Trading?

Risk management in trading is essential for averting the risk of bearing the losses arising from stock market trade. Risk management involves identification, evaluation and mitigation of risks which usually arise when the market moves in the opposite direction from the expectations.

So, it is really important to set your expectations on the basis of a thorough analysis of the market and after anticipating all the risks.

Trends are the most important factor here. A trend implies the general direction or momentum of the market, asset price or other such measures.

And a trend gets formed by the investors’ risk appetite which implies the risk anticipated in case of certain events such as elections (political events), interest rate decisions (economic events) and new advancements in technology (business events).

Hence, after anticipating such risks, you can invest in the stock market weighing your anticipated risks with your anticipated gains.

Find out about the changing notions of risk management in the current market in detail by our expert Rajib Ranjan Borah in this video:

Next, we will find out the identification as well as evaluation of trading risk.

Identification of Risks

While identifying the trading risks one needs to know the different variables at play in the market.

These variables can be economic factors such as decisions of interest rate by the central bank or a trade war.

While making our trading decisions, we must ensure that we are taking into consideration those economic factors which can affect our assets.

Here, we are mentioning the power of these factors to create possible price fluctuations of these assets and if they actually do affect the prices a lot then we must know the frequency of these factors.

Finding out these important points will help us with identifying these factors as a potential threat to the portfolio. This way, we can be prepared to tackle the risky scenarios in the market with the help of practices such as hedging, investing in options, diversification of assets into low risk and high risk etc.

Suggested Read: Articles on Portfolio & Risk Management

Let us now head to the evaluation of trading risks.

Evaluation of Trading Risks

The trading risk evaluation implies finding out the performance of a portfolio in the market.

There are two ways to evaluate the risk in the market. One is with Alpha and another is with Beta.

Alpha is the measure of an investment’s performance compared to a certain benchmark. The excess return of the portfolio over the benchmark index is the portfolio’s alpha. If alpha is positive the investment has outperformed its benchmark. Similarly, if it is negative then the portfolio has underperformed. An alpha of 0 would indicate that the portfolio is following the benchmark perfectly.

For example, an alpha of 1 means the fund has outperformed the returns of the benchmark index by 1% and an alpha of -1 means the fund underperformed by 1%.

Suggested Read: Alpha Generation - Controlling Intraday Risk Profile

Beta is a measure of the volatility of a security or a portfolio in comparison to the market as a whole. In general, a beta more than 1 indicates that the portfolio or security is more volatile than the market, while a beta of less than 1 indicates that the investment is relatively less volatile. Low beta stocks are also called defensive stock because investors like to hold them when the market is particularly volatile. High-beta stocks tend to be favoured when the market is rising steadily and investors are happy to take greater risks in order to maximize profits.

For example, if a stock's beta is 1.5, theoretically it is 50% more volatile than the market. Conversely, if a stock’s beta is 0.60, theoretically it is 40% less volatile than the market.

Next, we will find out the risk management approaches which help with good money management.

Suggested Read: Dynamic Money Management

The most popular risk management strategies and elements to make your trades successful while evading risks are as follows:

  • Portfolio optimisation
  • Hedging
  • 1% rule and 2% investing rule
  • Monitoring the trade while utilising advanced technology
  • Avoiding unclear trade setups
  • Stop loss

Portfolio optimisation

Portfolio optimisation is the process of constructing portfolios to maximize expected return while minimizing the risk. It involves analyzing portfolios with different proportions of investments by calculating the risk and the return for each of the portfolios and selecting the mix of investments which achieves the desired risk versus return trade off.

Modern portfolio theory, a hypothesis which was put forth by Harry Markowitz in 1952, assumes that an investor wants to maximize a portfolio's expected return for a given amount of risk, with risk measured by the standard deviation of the portfolio’s rate of return. The risk and return of a portfolio can be plotted on a graph as:

The optimal risk portfolio is usually determined to be somewhere in the middle of the curve because as you go higher up, you take proportionately more risk for a lower return, and as you go lower in the curve the portfolio returns are very low, so investing in such a portfolio would be pointless as you can achieve similar returns by investing in risk-free assets.

Hedging

Hedging is an investment strategy designed to offset a potential loss. In other words, hedging is investing to reduce the risk. Hedging against market price risk means to protect yourself from the adverse movements in prices by attaining a price lock. This is done by using offsetting contracts against the natural position you hold while hedging against credit risk.

Hedging can be done using derivatives, as the relationship between derivatives and their corresponding underlying is clearly defined in most of the cases. Other financial instruments like insurance, future contracts, swaps, options and many types of over-the-counter products are used to hedge.

Example

Let us assume company ABC produces corn flakes as a breakfast product to its consumers. Then for company ABC, fluctuations in the price of corn in the commodities market is a risk. Since company ABC is in a natural short position (since it is selling corn as corn flakes), it will have to make sure the price of the corn does not rise invariably during the process of procurement of corn. The company will enter into offsetting long contracts in the corn future market say at $400/bushel. Tomorrow, if the spot price of corn is $425/bushel, company ABC has successfully hedged this price variability by entering into long futures contract for its corn procurement. And if, the spot price is less than $400, say $375/bushel, still the company ABC will buy corn at $400/bushel since it has already entered into a future contract. Hence company ABC attained a price lock of $400/bushel.

Meaning and Importance of 1% Rule & 2% Investing Rule

1% and 2% rule in trading imply the maximum amount of the risk which is feasible on per trade should be either 1% or 2%.

This helps you to avoid the excessive loss that may happen otherwise. Hence, no more than 1% or 2% of capital should be risked on the single trade. This is usually possible with day trading.

For instance, a trader holding $10,000 of capital would not risk more than $100 on the single trade.

Monitoring the trade while utilising advanced technology

It is very important that you monitor your trades. Monitoring the trade can be done with:

  • Utilising algorithmic trading - The trend of the stock keeps changing and to make the most out of your trades it is extremely important/crucial to keep a check on the change in the market. In today’s advanced trading, automated trades have made it much easier to find out the most gainful position and invest automatically since the trades are algorithm-driven. This is known as algorithmic trading. Technologies such as neural networks, machine learning and deep learning models help with the automation of monitoring as well as for deciding the trade positions even within a fraction of seconds.
  • Backtesting the strategies - Backtesting is the process of testing a trading strategy using historical data to determine the effectiveness of that strategy. Backtest results usually show the strategy’s performance in terms of some popular performance statistics like Sharpe Ratio and Sortino ratio, which help to quantify the strategy’s return on risk. If the results meet the necessary criteria, the strategy can be implemented with some reasonable degree of confidence. If the results are less favourable, the strategy can be modified, adjusted and optimized to achieve a desirable result.

Avoiding unclear trade setups

An unclear trade setup takes place when one of your indicators agree to a certain trading position but others do not. For instance, if you are using the moving indicators like EMA, MA, etc. and one of them shows a clear trade setup but does not agree with the trade setups of other indicators, it creates confusion.

In such a scenario, it is best to wait for the right trade and not make any decisions when you are not sure about it. A set of mixed trade setups should never be the base of your decision making.

Stop loss

Stop loss is a buy or sell order which gets triggered when the stock price reaches a specified price known as the stop price. Stop loss is extremely useful for the investor who doesn’t want to monitor the security on a continuous basis. The other advantages of using stop loss are to offer protection from excessive loss and to enable better control of your account. One of the disadvantages of the stop loss is that it is mostly a market order and hence, it exaggerates the loss.

For instance, Suppose you buy the stock XYZ at $50 per share that you feared might drop in price, you could use a stop order to sell if the price dropped below $45 per share to protect yourself against a larger loss.

Also, you can watch this elaborative video to find out more about risk management practices from one of our experts Marco Nicolas Dibo:

Conclusion

With the trading practice, it is extremely important to make sure that your trades are secure with right risk management at place. Having a good knowledge of the risk management practices and strategies is a boon for any trader since it helps you minimize losses and maximize gains. With the right identification and evaluation of your risks, you can successfully manage the same.

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