Market risks are risks that you can take that are associated with movements of market prices. Market prices include changes in equity, commodity, interest rate, or even currency rates. Market risks are sometimes difficult to measure as a portfolio of financial instruments can be subject to transparent market movements or changes in value due to opaque risks. The measurement of market risk can come in many formats which include the percent change of a financial instrument to the value at risk of a portfolio. Management techniques to mitigate market risk are a key element for investors in trading a successful portfolio.
Risk Management on Trades
Trading the financial markets requires a sound strategy that employs robust research, a technique for initiating a trade and solid risk management. Risk management as it pertains to individual trades focuses on the exit point of a trade which is often overlooked when a trade is initiated.
Money management focuses on the amount of capital that will be risk on a specific trade. This concept can be broken down into the expected gain or loss as it relates to return on a trade, along with the potential bet size for each trade.
Prior to initiating a trade, an investor should formulate a strategy in which they will determine the appropriate profit and loss that they are willing to accept.
An investor needs to determine a prudent risk reward profile in which the profit is a multiple of the loss. The risk reward profile is how much you will potentially lose compared to how much you plan on making. Although there are a number of trading strategies that win more than they lose, there are very few that will be successful over time if the amount of loss on a trade is a multiple of the profit made on a winning trade. Part of your risk management strategy is to determine how to deal with leverage. Leverage your ability to purchase an asset using borrowed capital.
Risk management is the core of your trading strategy. Assume you have a trend following strategy that is focused on catching large moves in a specific group of securities such as currency pairs. If you understand that you will likely lose more times that you win, then making more than you lose is imperative to generate a winning strategy.
For example, if you make twice as much as you lose on wining trades than on losing trades then you only need to win 33% of the time. Let’s assume 3 trades. If you have 1 winning trade at $66 dollars and 2 losing trades at $33 dollars then the strategy would be break even.
From this example, the risk profile shows that the winners and the loser would cancel each other out, generating zero profit. Slightly more than 33.3% would allow an investor to generate gains. A different risk reward profile would require either a greater percent of gains on the strategy or a more robust risk reward profile to generate a successful strategy. For example, if you earn 3 times as much on a trade and win 33% of the time, you will have a very successful strategy.
Risk management is the backbone to trading the markets. By creating a sound risk management practice, you will be able to exploit your entry techniques, and generating a successful trading strategy.