What is risk management?

Prices can go up, and prices can go down. One of the key parts to a successful trading plan is to ensure you manage your risk properly because, as any trader who's been in the game for long enough will know, you can't get it right every time.

In finance, risk is defined as the potential for the actual return on an investment to be lower than the expected return.

This includes the potential for loss and - if you're trading using leverage - the potential to lose even more than you put in.

Risk management is a set of rules and measures you can put in place to ensure the impact of getting a decision wrong is manageable.

In fact, traders with particularly effective risk management strategies can still make money even if they lose more trades than they win. That's because their winning trades are, on average, more profitable than their losses.

We'll look into how that works a bit later, but first let's run through the three main types of risk you can come across when trading.

Market risk

By far the most familiar type of risk is market risk. This is the possibility you will suffer losses due to movements in market prices.

The four factors that have the greatest impact on market prices are:

  • Interest rates
  • Stock prices
  • Foreign exchange rates
  • Commodity prices

It's worth noting that these factors do not directly have to change the price of the market you're trading to have an effect.

For example, if you're trading a US stock from the UK, your profit or loss can be affected significantly by the GBP/USD exchange rate - even if the market price of the stock stays the same.

Similarly, market prices can be influenced by many different elements working together or against each other.

If you're trading on a major mining stock like Antofagasta, for instance, commodity prices will have a large effect on its share price - particularly copper as that's the main commodity the company produces.

As most commodities are denominated in US dollars, the strength of the dollar will have a significant bearing on commodity prices and in turn the stock itself. Also, shifting monetary policy in China could potentially boost or dampen building expansion in the country, increasing or reducing global demand for commodities as building materials. This again could affect the mining company's share price.

So, it's important to recognise that market risk can come from a number of different sources, some of which may not be immediately obvious when you first look at potential trading opportunities.

Liquidity risk

Less well known, but still very significant, is liquidity risk. This is the risk that you can't buy or sell an asset quickly enough to prevent a loss. There are two main types:

  • Asset liquidity risk refers to the asset's ability to be traded in the market. If, for example, you hold a little-known stock and nobody wants to buy it, you may be forced to sell at a less favourable price. This type of risk tends only to be an issue in emerging or low-volume markets.
  • Funding liquidity risk is the potential for loss if one of the parties involved in a trade cannot meet their financial obligations when they need to. The resulting time delay could have an impact on market prices, or may cause the trade to fall through altogether.

Systemic risk

Finally there's systemic risk - the risk that the entire financial system will be affected by a particular event or series of events.

This occurred during the global financial crisis of 2008 where subprime debt issues and the subsequent collapse of major financial institutions, such as Lehman Brothers, caused stock markets to drop worldwide.

As its effects are global, systemic risk is often very difficult to protect yourself against - though investors with more diverse portfolios tend not to be as badly affected as those who invest in just one sector or asset type.

Other examples of systemic risk can include natural disasters, war and major political or regulatory change.

Lesson summary

  • Risk management is a set of rules you can use to ensure getting a decision wrong is manageable
  • Market risk is the potential to suffer loss due to movements in market prices
  • Liquidity risk is the potential to suffer loss because you can't buy or sell an asset quickly enough
  • Systemic risk is the potential for the entire financial system to be affected by an event or series of events
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