The framework that defines how a company/investor handles financial risks.
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When opportunity knocks, it can be easy to lose sight of what can happen if a trade or investment doesn’t work out the way we hope it does.
As a trader learns about how to read charts and execute trading strategies, one of the key steps to success involves gaining an understanding of financial risk and portfolio management.
Learning about risk and how to manage it enables traders to avoid losing their bankroll - and potentially more - when executing their trading strategies.
In this edition of our Education 101 Series, we’ll talk about financial risk, explain how to manage risk effectively, and describe the psychology of market cycles to provide the insight you need to safely manage your money and start optimizing your trading strategies.
What is Financial Risk?
Financial risk deals with the danger of losing money. As previously mentioned in our article on finance, finance can be divided into three categories: personal, corporate, and public finance:
- People and families experience financial risk when they make decisions that impact their career and ability to pay their debts.
- Businesses take on financial risk when making decisions about how to provide their products and services.
- Governments take on risk when making decisions about how to collect taxes and spend money
Of course, even getting out of bed in the morning technically comes with a little risk. The goal shouldn’t be to avoid risk entirely; we just need to be able to manage it effectively.
What is Risk Management?
Strategic thinkers know “the best offense is a good defense” and to play good defense, you need to know what you’re up against.
Risk management is about trying to understand where the potential losses associated with an investment can come from and helping people build portfolios in accordance with their appetite for risk.
Whether we’re thinking about a single person’s investment portfolio or the portfolio of a major financial institution, risk tolerance describes the types of risk, and how much of that risk, an investor or group of investors wants to deal with.
Savvy investing isn’t just about finding investments that provide great returns: it also requires the ability to be patient and avoid losses in order to have the ability to take advantage of great investment opportunities. This is referred to as portfolio management.
Risk in Trading
The first step to evaluating trading opportunities is to learn about the different types of risks and rewards associated with different strategies. This gives us the insight we need to decide how much risk we’re comfortable taking on when executing trades.
To assess the potential risks and rewards of different opportunities, traders examine benchmarks like alpha and beta.
- Alpha is a measurement of how much the returns on a given investment can potentially beat the returns associated with a market index or some other benchmark.
- Where alpha examines the returns compared with a benchmark, beta measures the potential risks.
If we can simply place money in an index fund that tracks the stock market and expect an average return of 8%, why would we waste our time with trading strategies that offer the same, or even slightly higher returns given the amount of work involved in active trading?
When evaluating trading strategies, traders want to find strategies enabling them to maximize their alpha while minimizing their beta. Accomplishing this means considering how much money to risk on a trade and how long it will be exposed.
The first step in calculating the potential risk and reward of making a trade is to divide our potential profits by the number of funds at risk. A good trader would never consider risking all of their funds on a single trade.
Use The 1% Rule
Many traders stick to the 1% Rule, which says a trader shouldn’t put more than 1% of their funds at risk when making a trade. For example, if a trader has set aside $50,000 to trade with then sticking to the 1% rule means not risking more than $500 on any given trade.
The second step in calculating risk is to decide how much time to give a trade before moving on to the next opportunity. What’s the point in letting a trade continue on indefinitely when we could be using those funds to find better opportunities?
To review, a trader should always decide when they will either take profits or stop losses before entering a trade.
Now that we’ve talked about some of the strategies traders use to manage risk, let’s zoom out and talk about some of the important patterns traders should be aware of when conducting their trades.
The Psychology of Cycles
When it comes to evaluating different trading strategies, timing is everything.
Strategies may seem golden at one moment, providing luxurious returns on even the most meager investments, and suddenly sink a portfolio into a sea of red the next.
An important key to understanding fluctuations in the price of assets is to observe the trends that have emerged throughout their history.
- The Market Cycle refers to a pattern in the rise and fall of the price of an asset over a long period of time.
- The Business Cycle tracks the rise and fall in the production of goods and services in an economy.
- Debt Cycles follow fluctuations in the total amount of household and government debt.
Observing cycles and understanding where the market currently stands helps traders identify different trends in various markets and provides insight into how other traders are thinking about the market.
Each of these cycles occurs in four stages:
- Accumulation occurs when the market has dropped and speculators begin to buy back in, assuming the worst is over.
- Markup happens after prices stabilize start moving higher.
- Distribution is marked by the price peaking and beginning to turn around.
- A downtrend, as the name suggests, happens when the price is falling.
Generally speaking, traders who simply want to “buy low and sell high” can observe market cycles to help decide when they should buy and sell different assets.
When the market enters the markup phase, it’s probably a good time to sell assets. Downtrends, on the other hand, can provide a good opportunity to buy assets.
A trader’s strategies may work well during certain phases of certain cycles and stop working altogether during others. Learning different strategies and how to apply them effectively is what being a successful trader’s all about!
So, what next?
Once we understand the different types of risks and rewards associated with different assets and trading strategies and how they fit in with our appetite for risk, then we can start looking for good opportunities to execute trading strategies within those asset classes.
Stay tuned for the next article in our Education 101 Series! We’re creating a Glossary of Financial Risk to help you learn more about the different types of risk to consider when honing your trading strategies.
Follow along as we add to our Binance.US Education 101 Series: Your Guide to Crypto Literacy
#1 Demystifying Digital Dollars
#2 Evolution of the Internet
#3 Finance, Rhymes with …
#4 Back that Asset Class Up
#5 What are Cryptocurrencies?
#6 Defining Decentralized Finance
#7 Cryptoeconomics Explained
#8 Intro to Consensus Algorithms
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