The framework that defines how a trader handles financial risks.
We are constantly managing risks throughout our lives - 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 trader handles financial risks, which are inherent to all kinds of businesses.
For traders, 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 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.
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.
The second step involves detecting and defining what the potential risks are. 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 isn’t directly related to financial risks.
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.
The fourth step consists of defining responses for each type of risk, according to their level of importance. It establishes what is the action to be taken in case an unfavorable event occurs.
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) don’t need to trust each other.
- Operational risk – Traders can mitigate operational risks by diversifying their portfolio, 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.
Before opening a trading position or allocating capital to a portfolio, traders should consider creating a risk management strategy. Still, it’s important to keep in mind that financial risks can’t be completely avoided.
Overall, risk management defines how to handle risks, but it’s certainly not only about mitigating risks. It also involves strategic thinking so that the unavoidable risks can be taken in the most efficient way possible.
In other words, it is 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.
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