Risk Management Strategies

Risk Management Strategies

Why is it Important to Implement Risk Management Strategies?

Risk management strategies are highly effective because risk is pervasive. Without a proactive approach to mitigating against risk, certain failure will result. A steadfast approach to dealing with challenges is necessary in order to overcome them. Commitment, focus, and determination to succeed will win out in the end. In much the same fashion, this philosophy can be applied to finance, trading, and investing. Whatever your short-term focus, or long-term objectives, hedging against risk is sacrosanct.

Whenever capital is transferred from the relative safety of an interest-bearing account to the uncertainty of the financial markets, risk is present. The prospect of profit must be weighed up against the risk of loss. Your profit potential is a product of your ability to understand the financial markets, make informed trading decisions, utilise trading tools and resources, and implement effective risk management strategies.  Today, we’re going to focus on arguably the most important component of your trading regimen – risk management strategies.

Table of Contents

Risk Management in Finance

When it comes to financial activity, risk management refers to a set of processes that are undertaken by the trader/investor to assess risk, and mitigate against risk. This is done to protect against losses in trades and investments. Loss occurs when the market moves in the opposite direction to expectations. Many first-time traders believe that losses only occur when the price of financial instruments declines, but this is not the case. It is possible to profit from rising and falling asset prices, provided you call it correctly.

It is said that the ‘Trend is Your Friend’, and traders are routinely encouraged to go with the flow. While this is generally true, trends can suddenly reverse. That’s why it’s important to have a thorough understanding of the technical indicators in the market. Many different factors influence trends, and we will examine them as we progress through this comprehensive risk management assessment. Broadly speaking, various elements can impact market trends such as the state of the nation, technological developments, the inflation rate, interest rate, consumer sentiment, GDP, employment, non-farm payrolls, et cetera.

Why is Risk Management Important for Traders?

In the financial arena, risk management is absolutely essential. If you don’t implement risk management strategies, you may lose all of your capital. The purpose of risk management is therefore to mitigate against unfavourable market movements. We may be tempted to take advantage of every single trading opportunity that comes our way, but it’s imperative that we understand the investment risks ahead of time. By planning ahead, we can ensure that we are not left behind.

The objective of trading is to generate an ROI. Ideally, you want a sustainable and ongoing source of revenue from your trading activity. That’s why an effective risk management strategy is so important. A comprehensive forex risk management strategy and trading plan can help you achieve your objectives.

Focus: A Trading Plan & Risk Management Strategy

Successful forex traders understand that any effective Forex Trading Plan coupled with a Forex Risk Management Strategy can work in unison to achieve the desired results. Consider the elements of an effective trading plan:

  • The financial instruments that you focus on
  • Trading with your head and not with your heart
  • Timing trades to perfection with entry/exit points
  • Setting the correct profit and loss limits for trades
  • What actions to take when the market turns against you
  • Assessing the viability of different trading opportunities
  • Measures to implement to stay focused on your trading plan

When trading currency pairs, risk management is sacrosanct over the long-term. As you will soon learn, the forex markets are highly liquid, volatile, and exciting. This presents the potential for many profitable trades. Successful forex traders can rollover money in double-quick time, generating tremendous earning potential when trades go well. Thanks to leverage and rapid cycling of capital, a relatively small stash of cash can be transformed into something substantial.

Truth be told, the majority of forex traders actually fail. It’s not for lack of desire to generate profitable trades; it’s the absence of risk management strategies, discipline, budget control, decisiveness, knowledge, and myriad other factors that work together to ensure your success. If risk management strategies are not implemented, trades can rapidly go south and capital can be depleted overnight. All it takes is one bad trade to blow you out of the water, and that’s precisely what you don’t want to happen as a forex trader.

The best way to guard against losses is by implementing a well-structured risk management strategy. This will help you to stay profitable over the long-term. In so doing, you will be able to generate a steady stream of income which can certainly grow substantially over the long-term.

Implementing Risk Management in Trading

Recall that we defined risk as an unfavourable situation where the expected outcome is different to the actual outcome. With risk, the market moves contrary to what you anticipated and results in a loss of your capital. The broad definition of risk does not specify how much movement is required, or how great your losses will be. Suffice it to say, risk is regarded as a negative deviation from an expected outcome.

Consider a situation where the market moves in your favour, but much greater than you expected. Clearly, this does not meet the definition of risk in that sense of the word, since it is a positive surprise which adds to your returns. Now, when the market movements are negative – the market moves against you – you will likely earn less than you anticipated, perhaps breaking even, or making a loss.

The macroeconomic elements that factor into the equation have an impact on the size and direction of price movement, and the pace with which these fluctuations occur. When there are sizeable price fluctuations over the short-term, volatility results. Your risk tolerance is important when it comes to coping with sustained periods of volatility. Your ability to manage volatility reflects your mental fortitude when trading.

Remember the age-old axiom, ‘No Risk, No Reward’ – the greater your ability to effectively deal with high-risk situations, the more likely you are to generate returns from your trading activity. Many day traders believe that the purpose of trading is to generate an ROI. To a certain degree, this is certainly true, but the raison d’être for trading is the acquisition of knowledge. Profit is a byproduct of a trained mind, a successful trading regimen, and the implementation of highly-effective risk management strategies.

There are 3 essential phases involved in creating a risk management strategy. These include the following:

  • Risk Identification
  • Risk Assessment
  • Risk Mitigation

Each of these three elements will be discussed in much greater detail in the sections that follow.

Risk Identification: How Are Financial Risks Identified?

Knowledge is key to identifying financial risks. You need to understand all of the variables that are involved. There are a series of primary economic factors, including, interest rates, inflation rates, trade policy, employment data, GDP, credit ratings, et cetera. These macroeconomic indicators are powerful identifiers of potential risk. If a country has just received a downgrade from credit ratings agencies, this does not bode well for investment purposes. If interest rates are going to increase, this diminishes prospects for a booming property market et cetera.

There are of course secondary indicators to consider. These are largely internal economic reports, and they impact consumer, trader, and investor confidence. They have an impact on trends over the short-term, and the medium-term. On a tactical level, there are tertiary economic indicators to consider. These include quarterly earnings reports from companies, sectors, or assets. Be advised that the impact of tertiary indicators is limited in scope, but capable of generating an outsized impact in your chosen financial instruments.

Naturally, there is a glut of information to factor into your equations with risk management strategies. All of the information is important, but not all of it is pertinent to your trading activity. When conducting forex trades, commodity trades, index trades, or stock trades, you must identify the most important factors, including economic events, reports, and other elements that are likely to affect your assets. That’s why it’s imperative that we focus our efforts on those elements which can cause price fluctuations in assets. The frequency of updates is equally important, as are the factors that play their part on the numbers in these financial reports.

There’s a lot of noise out there. Not all of it is relevant to your trading activity. We need to cut through the noise and focus on what matters. If it’s not relevant, it doesn’t matter. Our ability to understand risk, its core constituents, and the manner in which risk affects asset prices is important. With a trained mind it is possible to choose only relevant risk signals from the financial markets while putting together an effective trading strategy. This will guard against unfavourable price movements in your financial portfolio.

Risk Assessment: How to Evaluate Trading Risk?

There are several techniques used for assessing different types of trading risk. One of the most commonly used evaluation methods is the assessment of active risks and passive risks. For the purposes of illustration, active risks are risks derived from the trading strategies that you use. Passive risks are the risks derived from exposure of the financial investment to market events.

Active Risks & Alpha

Recall that active risks relate specifically to your trading strategy. Active risks are considered subjective risk exposure.

Alpha refers to the active risk ratio measuring the performance of assets using a reference security over time. When you use 0 as a point of departure, a positive alpha value indicates a higher percentage yield than the reference stock. A negative alpha value represents a lower return than the reference stock.

An example will help to clarify Alpha. Let us assume that we are computing the 30-day Alpha for Tesla (NASDAQ: TSLA), against the NASDAQ 100 index. If we generate a 4% figure, it means that Tesla had a 4% higher ROI (Return on Investment) than the NASDAQ 100 index over a specific period of time.

Passive Risks & Beta

Recall that passive risks are deemed objective risk exposure. They represent risks that are derived from market events outside of our control.

Beta refers to the passive risk ratio measuring tested volatility, vis-a-vis a reference security over time. We use 1 as the base figure, and any figure higher than 1 indicates that the asset price has a greater volatility than the reference security. A beta value less than 1 is reflective of lower volatility.

What does this mean?

A greater beta value indicates that an investment in the underlying security (stock, commodity, index, currency) will likely have bigger potential returns, but higher risk of loss than the reference security. By contrast, a lower beta value indicates much lower risk, and lower attendant returns.

An example will help to clarify Beta. It is assumed that we are calculating the Beta for PepsiCo Inc (NASDAQ: PEP) against the US 30 index. If we get a figure of 1.7, PepsiCo stock’s beta would be 0.7 higher than the benchmark stock’s beta. This means that Pepsi-Cola incorporated prices are 70% more volatile than the Dow 30 over that period of time.

How to calculate Alpha (α) & Beta (ß)

Calculating alpha and beta is easily done by following these 4-step rules:

Alpha (α) = Rp – [Rf + ß (Rm – Rf)]

Beta (ß) = Covariance (Re, Rm) / Variance (Rm)

  • Rp: % portfolio return -% portfolio return in the chosen period
  • Rm: market yield -% yield of the reference security in the chosen period
  • Rf: Return on a risk-free trade -% return on an investment with minimal risk
  • Re: return on equity -% return on shares in the chosen period

Another example will help to clarify the calculation of Alpha and Beta. Let us assume we wish to calculate the risk exposure of trading Amazon (NASDAQ: AMZN) stock in Q4, and use the NASDAQ 100 index as a benchmark. We make the following assumptions:

  • The portfolio return (Rp) was 15%
  • The return on the NASDAQ 100 (RM) index was 10%
  • The 3-month U.S. Treasury note (Rf) yield was 1%
  • The return on Amazon (Re) stock was 12%

Assuming a price correlation over any given time period of 0.9 (90%) between Amazon and the NASDAQ 100 index, and the NASDAQ price change of 1.35%.

We then calculate the covariance between Amazon stock and the market. We divide it by the market return and find beta to be 0.67, i.e. 67%. We use this value to determine alpha. By plugging the numbers into the formula, we find an alpha value of 7.97%.

Putting the data together, with Alpha at 7.97%, and beta at 0.67%, we can determine that over a specific period of time, Amazon was a better performer than the NASDAQ 100 index. It generated 7.97% greater return, with 33% less volatility.

How to Practically Apply Alpha and Beta in Trading Activity

As traders, we can determine the alpha & beta values from the prior performance of financial instruments, and the reference security over a specific period time. We then utilise this information to anticipate similar active/passive risk exposure over an equivalent period of time in the future.

We can use this information for any stocks. Let us take Apple Inc (NASDAQ: AAPL) as a case in point. When they launch a new product, we want to know how Apple shares are likely to perform. We could use a 3-month period as our reference time. By analysing the performance over time, we can identify the risk exposure of trading AAPL shares over the next 3 months.

The NASDAQ index serves as our benchmark, and we use it to calculate both the alpha & beta values. We can generate important results from the alpha & beta values following the 3-months after the previous launch of an Apple product. This gives us information about the active & passive risks over the next 3 months.

Of course, there are ways to enhance alpha & beta risk analysis, such as averaging multiple timeframes, and establishing confidence intervals. These broad-based approaches can certainly provide a window into the risk/reward potential of Apple stock following a new product release. Let’s take a look at these two elements:

Averaging Multiple Timeframes

Recall that our previous alpha & beta results used only the last product launch as a reference point. We can improve our estimates by taking multiple product launches into account say for the last 3 rollouts. We can determine the alpha & beta for each of those three and then average them out. We must also bear in mind that each period may have been subject to different market conditions which may not be relevant in the present. Market analysts utilise Alpha-weighted calculations and beta-weighted calculations by assigning greater relevance to the present time period over the past time periods.

Confidence Intervals

A powerful statistical tool that we can use to improve multiple timeframes is the standard deviation of alpha & beta values. When we establish confidence intervals in this way, we can generate a reliability percentage that the results will fall between specific values. If we get a 67% reliability, then we can assume that the result will be between a negative SD and a positive SD. We can also suggest with 95% confidence that the result will be between two negative SDs and two positive SDs.

Risk Mitigation: How to Reduce Risk with Risk Management Strategies

We have learned how to identify and assess the active risk that will occur with our trading strategies, as well as the passive risk that occur as a result of market conditions. Now, we turn our attention to 3 approaches for risk mitigation. These include budget-based approaches, portfolio diversification-based approaches, and hedging-based approaches.

The Budget-based Approach to Risk Management

This approach entails the establishment of money management strategies. We set up a capital distribution guide based on our available capital, trading objectives, and leverage that will be used. This will provide guidance on how our capital will be employed across our investments. It includes position sizing rules, profit/loss ratios, price targets, and exit strategies for investments.

Position Sizing Rules

This refers to the ratio of the size of a single position vis-a-vis capital. Successful traders understand that you should not invest more than 1% of your available capital in a single position. If you have AU$1 million to invest, no more than AU$10,000 should be invested in any individual position. This means that your margin per investment is AU$10,000. The remaining capital – AU$990,000 is your protection i.e. your buffer against volatility with respect to profit and loss, and it protects you from unfavourable movements. Naturally, specific assets are more susceptible to volatility than others. You will need to adjust your position sizing strategy to ensure an appropriate balance between your investment and the incumbent risk.

Profit/Loss Ratio

The Profit/Loss ratio refers to the percentage of trades that close profitably. If the ratio is 2 to 1, that means that 67% of trades close profitably. Be advised that percentages of winning trades do not indicate whether the portfolio is profitable as a whole. Consider a portfolio where 10 trades are conducted, and 6 of them generate profits of AU$1000 each, but the remaining 4 generate losses of AU$1500 each. On paper, the total profits of AU$6000 is equal to the total losses of AU$6000 – so the portfolio breaks even. This, despite the fact that 67% of the portfolio comprises winning trades!

To better understand the required Profit/Loss ratio, traders should create a Risk Reward Ratio, otherwise known as RRR. As a case in point, consider a RRR of 1:3. This means that the trader is willing to risk AU$1 for a AU$3 reward. If on the other hand, the ratio is 1:2, the trader is willing to risk AU$1 for a AU$2 reward. If the RRR is 1:1, then a 50% win rate is required. There are many different tools that can be used to determine the required Profit/Loss ratio based on the RRR.

Entering & Exiting Trades

Risk mitigation strategies rely on a trader’s ability to enter and exit trades at the right price points. Traders who know when to exit a position can keep a lid on their risk control strategies.  Many a trader has fallen by the wayside by staying in a winning position much longer than required, only to experience a market reversal that eliminates all gains.

By the same token, leaving a losing position open, hoping for a reversal can lead to substantial losses. In fact, many traders have lost all of their capital in such situations. As an FX risk management strategy, it is always best to set price targets. This means that stop loss orders and take profit orders must in place to automatically exit positions once they have been reached. Various technical indicators are used to identify price targets namely:

  • Support & Resistance price levels are hardly ever reached by the underlying financial instrument. The support level, is the base which the price tends to hover around. Think of a bucket holding water – the bottom of the bucket is the support level. A resistance level represents the price ceiling where the financial instrument tends to reach towards, but hardly ever breaches. The support level is invariably lower than the current price of the asset. When long positions are considered, resistance levels are the take profit levels. The support levels are the stop loss levels. Over the short-term, different support and resistance levels are used. Since the timeframe is dramatically reduced for this, Reward Risk Ratios are used.
  • Pivot Points (PP) average out the highs, the lows, and the closing price over a period of time. Pivot Points are otherwise known as Hinge Points. When the price moves higher than the Hinge, then the market is considered bullish. When the price moves below the Hinge, then the market is considered bearish. Pivot Points can be used alongside Support & Resistance price levels. When trend reversals take place in the markets, price movements beyond these Pivot Points would signify changing sentiment and a new Support and Resistance level will come into play.
  • Moving Averages (MAs) are technical indicators that delineate the average of previous prices. We can take a 15-day moving average as a case in point. This calculates the average price of the underlying financial instrument over the past 15 days. On stock charts, you will usually see 50-day MAs, or 200-day MA, representing the short-term moving average and the long-term moving average respectively. Moving averages are used as part of an overall trading strategy to identify target levels. When the prices are moving up and down after a spike, MAs can be useful.
    When assets reach intraday lows or highs, traders will use moving average lines to anticipate price movements. For example, price reversal can be deemed corrections and consolidations. The average lines tend to represent the upcoming target prices. Once a target price has been reached, new trends may form. Moving averages are particularly useful to see what the price of an asset is doing over time. If the spot price is more/less than the short-term or long-term moving averages, changes are afoot. This technical indicator should be used in conjunction with other indicators for a better assessment of price movements.
  • Average True Range (ATR) is a volatility indicator that measures the pace of price movements. It calculates a 14-day average of the price volatility. It does so by adding the high/low differences of the past 13 days and then adds the current intraday difference high/low. The total is then divided by 14. The result of the ATR indicates how much the asset price moves on average per day. Traders routinely use average true range analysis to compare the daily highs and lows so that they can understand whether the price has moved more or less than the average. If price movements are greater than the average the daily situation can be calculated. If the price has moved less than the daily average, there is still some wiggle room. Average True Range (ATR) analysis is useful for stop-loss orders.

Portfolio Diversification Strategies

Of all the recommendations to traders and investors, portfolio diversification is one of the most important. By diversifying into different assets and categories, you are effectively mitigating against the downside risk in one category. If you put all your eggs into one basket, and that basket falls, you risk losing everything.

It’s worth pointing out that different assets may still be heavily correlated and considered identical for investment/trading purposes. For example, if you invest in different tech stocks like Google (GOOG), Amazon (AMZN), and Apple (AAPL), and there is a tech stock crash, they all go down. True diversification invariably means that there is a difference between the factors that influence price activity of different assets.

There are positive correlations where prices move in the same direction, and there are negative correlations where prices move in opposite directions. Take the US dollar as a case in point. When the USD rises after a positive economic report, we will see the following:

  • Positively correlated assets
    Forex assets that move together such as the USD/CHF (US dollar/Swiss franc), or the USD/JPY (US dollar/Japanese yen) are positively correlated. They move together. If market movements are bullish, then you can expect these positively correlated assets to yield profits. By the same token, downward correlations are also positive correlations. So, if the market turns bad, expect losses with positively correlated assets too. There is greater risk exposure with positively correlated assets, and analysts routinely caution against them.
  • Negatively correlated assets
    Assets that move in opposite directions to one another are also available. These include currency pairs like the EUR/USD (Euro/US dollar), and the USD/JPY (US dollar/Japanese yen). When one of these currency pairs rises, the other falls, making these the perfect hedge against market volatility. Ultimately, losing positions in one will be balanced out by winning positions in the other. This is good for short-term trading and long-term trading too. It is true that overall profits are negligible with negatively correlated assets, and trading fees could wipe them out entirely. Another example of negatively correlated assets could be gold and tech stocks.
  • Assets with low/no correlation
    Assets with no price correlation whatsoever, or near-zero price correlations are also available. These include stocks like Gazprom and the USD/JPY. Profits/losses for Gazprom are unaffected by changes in the USD/JPY.  With these types of assets, risk is distributed among different holdings.

When traders/investors hedge, the same asset is traded in different directions. For example, buying Bitcoin (going long) and then taking out a short position on Bitcoin futures (going short) could balance out any losses experienced in either of those trades. It’s a risk mitigation strategy, not a profit maximisation strategy. If the primary position loses, then the secondary position will profit and mitigate your losses.

At AvaTrade Australia, you can use a variety of powerful tools and trading resources to manage risk. These include AvaProtect, and AvaTradeGO for mobile trading.  These risk mitigation options take the opposite position of the trades you have, allowing you to benefit from unfavourable market movements. This is what risk management looks like in practical terms.

Top Ten Risk Management Rules

Trading plans rely heavily on risk management. Various methodologies are implemented – strategic and mathematical – as part of a trading plan. Traders can practically apply various precautionary measures, including the following:

  1. Set a trading plan and stick to it.
  2. Trade with your head, not your heart.
  3. Limit your risk to what you can afford to lose, no more.
  4. Monitor the performance of your trades, and adjust accordingly.
  5. Limit use of leverage, and maintain margin levels that are affordable.
  6. Use the tools and resources provided by AvaTrade Australia to mitigate risk.
  7. Use automated trading features rather than leaving open positions unattended.
  8. Always implement a safety-first approach with stop loss and take profit orders.
  9. Manage your cost structure effectively – fees, commissions, rollovers, swaps, etc.
  10. Avoid trading during exceptionally high volatility, since markets are unpredictable.

Put Your Risk Management Theory to the Test at AvaTrade Australia

Now that you’ve got a firm handle on theoretical risk management strategies, it’s time to practically implement your knowledge. It is a process of trial and error. Some risk management practices work better than others, depending on the specific situation. You can implement effective risk management, and tweak them to perfection.

Over time, you will find that risk management practices will benefit your portfolio and help you to become profitable. We encourage you to start using AvaProtect to enjoy all the features and benefits that this risk management resource has for you. You’re welcome to register at AvaTrade Australia and use our demo-trading account, at zero risk. This is the best way to practically implement your risk trading plans.

FAQs about Risk Management Strategies

  • Why is Risk Management Necessary for Traders?

    Risk management strategies are designed to minimise risks when trading or investing. The markets are subject to a variety of forces, each of which has the potential to derail your trades. Various risk management strategies can be implemented, irrespective of the type of trader you are, or the current market situation. These include the 1% rule, stop loss & take profit, setting a trading plan, calculate your expected returns, diversified portfolio, and monitoring your trades. By implementing these strategies, you will realise improved ROI, and more consistent trading outcomes.

  • How Effective is the 1% Rule in Risk Management Strategy?

    Every trader/investor has a budget. This represents the available capital for trading purposes. If you allocate just 1% of your budget to any given trade, you are effectively hedging against unfavourable market movements. Excessive losses can result, if leveraged trades move against you. The rule is clear: Allocate no more than 1% of your capital to any individual trade. So, if you have AU$50,000 in your account, no more than AU$500 should be allocated towards a trade. Your portfolio should ideally comprise 100+ different asset combinations when your capital is fully employed.

  • Is there a Risk Management Strategy that is Best for Me?

    Risk is a fixed component of trading. You cannot eliminate risk entirely, since that is not the way the market functions. With that in mind, the best strategies are those which shift the risk away from you. For example, you can limit risk, shift risk, hedge against risk, or transfer risk, et al. By limiting risk, you are effectively magnifying your chances of winning trades. Anyone who wishes to avoid risk should rather invest in government bonds, or near-zero fixed interest bearing accounts. Stocks, commodities, forex, and indices are risk laden, but smart strategies can certainly mitigate risks.