What is risk management?
We are constantly managing risks throughout our lives â either during simple tasks (such as driving a car) or when making new insurance or medical plans. In essence, risk management is all about assessing and reacting to risks.
Most of us manage them unconsciously during everyday activities. But, when it comes to financial markets and business administration, assessing risks is a crucial and very conscious practice.
In economics, we may describe risk management as the framework that defines how a company or investor handles financial risks, which are inherent to all kinds of businesses.Â
For traders and investors, the framework may include the management of multiple asset classes, such as cryptocurrencies, Forex, commodities, shares, indices, and real estate.
There are many types of financial risks, which can be classified in various ways. This article gives an overview of the risk management process. It also presents some strategies that can help traders and investors mitigate financial risks.
How does risk management work?
Typically, the risk management process involves five steps: setting objectives, identifying risks, risk assessment, defining responses, and monitoring. Depending on the context, however, these steps may change significantly.
Setting objectives
The first step is to define what are the main goals. It is often related to the risk tolerance of the company or individual. In other words, how much risk they are willing to take to move toward their goals.
Identifying risks
The second step involves detecting and defining the potential risks. It aims to reveal all sorts of events that may cause negative effects. In the business environment, this step may also provide insightful information that isnât directly related to financial risks.
Risk assessment
After identifying the risks, the next step is to evaluate their expected frequency and severity. The risks are then ranked in order of importance, which facilitates the creation or adoption of an appropriate response.
Defining responses
The fourth step consists of defining responses for each type of risk according to their level of importance. It establishes the action to be taken in case an unfortunate event occurs.
Monitoring
The final step of a risk management strategy is to monitor its efficiency in response to events. This often requires a continuous collection and analysis of data.
Managing financial risks
There are several reasons why a strategy or a trade setup may be unsuccessful. For example, a trader can lose money because the market moves against their futures contract position or because they get emotional and end up selling out of panic.
Emotional reactions often cause traders to ignore or give up their initial strategy. This is particularly noticeable during bear markets and periods of capitulation.
In financial markets, most people agree that having a proper risk management strategy contributes drastically to their success. In practice, this could be as simple as setting Stop-Loss or Take-Profit orders.
A robust trading strategy should provide a clear set of possible actions, meaning that traders can be more prepared to deal with all sorts of situations. As mentioned, though, there are numerous ways of managing risks. Ideally, the strategies should be revised and adapted continuously.
Below are a few examples of financial risks, along with a short description of how people can mitigate them.
Market risk: Can be minimized by setting Stop-Loss orders on each trade so that positions are automatically closed before incurring bigger losses.
Liquidity risk: Can be mitigated by trading on high-volume markets. Usually, assets with a high market capitalization value tend to be more liquid.
Credit risk: Can be reduced by trading through a trustworthy exchange so that borrowers and lenders (or buyers and sellers) donât need to trust each other.
Operational risk: Investors can mitigate operational risks by diversifying their portfolios, preventing exposure to a single project or company. They may also do some research to find companies that are less likely to experience operational malfunctions.
Systemic risk: Can also be reduced by portfolio diversification. But in this case, the diversification should involve projects with distinct proposals or companies from different industries. Preferably the ones that present a very low correlation.
Common risk management strategies
There is no single way to approach risk management. Investors and traders often use a combination of risk management tools and strategies to increase their chances of growing their portfolios. Below are a few examples of strategies that traders use to mitigate risks.
1% trading rule
The 1% trading rule (or 1% risk rule) is a method traders use to limit their losses to a maximum of 1% of their trading capital per trade. This means they can either trade with 1% of their portfolio per trade or with a bigger order with a stop-loss equal to 1% of their portfolio value. The 1% trading rule is commonly used by day traders but can also be adopted by swing traders.
While 1% is a general rule of thumb, some traders adjust this value according to other factors, such as account size and individual risk appetite. For instance, someone with a larger account and conservative risk appetite may choose to restrict their risk per trade to an even smaller percentage.
Stop-loss and take-profit orders
Stop-loss orders allow traders to limit losses when a trade goes wrong. Take-profit orders ensure that they lock in profits when a trade goes well. Ideally, stop-loss and take-profit prices should be defined before entering a position, and the orders should be set as soon as the trade is open.
Knowing when to cut losses is essential, especially in a volatile market where prices can tumble rapidly. Planning your exit strategy also prevents poor decision-making from emotional trading. The stop-loss and take-profit levels are also essential for calculating the risk-reward ratio of each trade.
Hedging
Hedging is another strategy traders and investors use to mitigate financial risk. It consists of taking two positions that offset each other. Simply put, traders can hedge one trade by making an opposing trade of similar or equal size.Â
It may seem counterintuitive to enter positions in opposite directions, but if done properly, hedging can reduce the impacts of a market move. For instance, imagine that you are long BTC and holding it in a personal wallet. If the market enters a downtrend, you could take a short position to offset your long position without having to move your BTC. This is what we call a market-neutral strategy.Â
If youâre trading futures, you can trade via Hedge Mode on Binance Futures to hold positions in both long and short directions simultaneously under the same contract.
Diversification
As the old saying goes, you should not put all your eggs in the same basket. In other words, diversify your portfolio. In theory, a well-diversified portfolio offers more protection against massive losses compared to a portfolio made up of only one single asset. If you hold a crypto asset in a diversified portfolio, the maximum damage you would receive if its price tumbles is a percentage of your portfolio. On the contrary, if your portfolio is completely made up of a single asset, then you could potentially lose 100% of your portfolioâs value.Â
Risk-reward ratio
The risk-reward ratio calculates the risk that a trader will be taking relative to the potential reward. To calculate the risk-reward ratio of a trade youâre considering, simply divide the potential loss by the potential profit. So if your stop-loss is at 5% and your target is at 15% profit, your risk-reward ratio would be 1:3, meaning that the potential profit is three times higher than the risk.
Closing thoughts
Before opening a trading position or allocating capital to a portfolio, traders and investors should consider creating a risk management strategy. Still, itâs important to keep in mind that financial risks canât be completely avoided.
Overall, risk management defines how to handle risks, but itâs certainly not only about avoiding risks completely. It also involves strategic thinking so that the unavoidable risks can be taken in the most efficient way possible.Â
In other words, itâs also about identifying, assessing, and monitoring risks, according to the context and strategy. The process of managing risks aims to evaluate the risk/reward ratio so the most favorable positions can be prioritized.