What is Risk Management in Finance?

Risk management in the Finance industry refers to the process of identifying, evaluating, and mitigating risks of losses in an investment. Risk of loss arises when the market moves in the opposite direction of our expectations. The trends are formed by the investors’ risk sentiment, which can be influenced by multiple factors. These factors are primarily political events such as elections, economic events such as interest rate decisions, or business events such as new technologies. 

Importance of Risk Management for Traders

We apply risk management to minimise losses if the market tide turns against us after an event. Although the temptation of realising every opportunity is there for all traders, we must know the risks of an investment in advance to ensure we can endure if things go sour. All successful traders know and accept that trading is a complex process and an extensive forex trading risk management strategy and trading plan allow us to have a sustainable income source. 

Trading Plan and Risk Management

The main difference between the successful and the unsuccessful traders is the quality of their forex trading plan and Forex risk management strategy. A good trading plan outline includes:

Why is Forex risk management important in the long run?

Forex markets are tempting in the sense that they have many trading opportunities that can potentially make large profits quickly and invest large amounts in single positions. However, most traders soon realise that it’s not a sustainable approach, and after a couple of trades, a single loss can wipe out the portfolio. Implementing a well-designed and detailed risk management strategy will allow us to remain profitable in the long run and create a steady source of income which we can augment over time.

How Risk Management Works?

Risk is the probability of the actual return on investment (ROI) deviating from the expected return. The deviations occur due to the events during a trade and vary in direction and magnitude. A favourable event may lead to a positive deviation, making us more-than-expected profits. Unfavourable events can cause negative deviation, which can mean earning less-than-expected, breaking-even, or incurring a loss. Each market-influencing event factor affects the trading volume in terms of position frequency, size, and direction – creating a variance in the speed and intensity of price fluctuations. This is called volatility.

Our financial capacity and psychological resilience to endure high volatility determine our risk tolerance. The higher our risk tolerance is, the higher return potential we will have. In order to understand our risk tolerance and create a plan accordingly, we need to have a risk management plan. The process of managing risks is comprised of three important steps: identification, evaluation, and mitigation. You can find a risk management plan example below.

Identification: How to Identify Financial Risk?

Identifying financial risks requires knowledge of the different variables that are in play. Primary economic factors such as interest rate decisions and trade wars usually have a market-wide effect on all industries. Secondary economic factors like economic reports affect the investor and consumer confidence and shift the short- and medium-term trends. Tertiary economic factors like quarterly earnings reports inform about specific industries or financial assets. Although the range of impact is limited, they can cause massive movements in the target assets. The range of information is wide, but not all of it is relevant to us. In our trading plan, we should first identify which economic events can affect our assets. Then, we should note their characteristics in terms of power to fluctuate prices, the frequency they are published, and the factors which can affect the numbers in these reports. Establishing the scope of information to monitor would allow us to eliminate the noise and focus on the relevant news.

Next, we should describe the probable scenarios for each report and whether they would have beneficial or adverse effects on our investment. Distinguishing the risky scenarios will allow us to select the related signals in the markets and prepare ourselves for any troubles our portfolio may face.

Overall, there are two types of risks in finance: systematic risk and systemic risk. Systematic risk is the risk inherent in a particular financial asset or even an entire market or industry. This inherent risk is external and beyond the control of any individual or entity. Systematic risk is non-diversifiable, and all financial investments are subject to it. This means that having a diversified portfolio does not mitigate or eliminate systematic risk. Systematic risk includes market risk, interest rate risk, inflation risk, and exchange rate risk.

Herd mentality is the source of market risk. It is often observed that markets can be influenced by the collective emotion or instincts of participants and not necessarily by solid fundamentals. This can also be referred to as market sentiment. Traders or investors tend to copy or follow what their fellow traders and investors are doing, such that if markets are falling, prices of good performing assets can also fall along or stagnate. Market risk is by far the most significant and most observed type of systematic risk.

A recent example would be the 2008 collapse of Lehman Brothers, a powerful investment bank that was founded in 1847. The firm was deeply interconnected in the global economy, and its bankruptcy literally brought the financial system to its knees.

Because of its possible devastating effects, mitigating systemic risk is a daunting task that cannot be handled by investors. It requires proper and relevant regulation as well as a ‘system’ of quick reporting of weak spots.  

Evaluation: How to Evaluate Trading Risks?

There are several methods to evaluate different trading risk types. The most common risk evaluation methodologies include management of active risks and passive risks. Active risks refer to the risks arising from the trading strategy employed in the portfolio, and passive risks refer to the risks arising from the exposure of the investment to the market events.

Active Risk and Alpha

Active risks can be thought as the subjective risk exposure and represent the risks arising from our trading strategy. Alpha is the active risk ratio which measures the performance of an asset against a benchmark in a time period. Using zero as a baseline, a positive alpha indicates higher return percentage than the benchmark, while a negative alpha indicates a lower return. For example, if we calculate 30-day alpha for Facebook (NASDAQ: FB) against and get 3%, it means Facebook had 3% higher return on investment than US_Tech100 in that period. 

Passive Risk and Beta

Passive risks can be thought as objective risk exposure and represent the risks arising from the market events out of our control. Beta is the passive risk ratio which measures the volatility of an asset against a benchmark in a time period. Using 1 as a baseline, a beta higher than 1 indicates that the asset price has a higher volatility than the benchmark price, while a beta lower than 1 indicates lower volatility. A higher beta would indicate that investing in this stock would have higher return potential but also higher risk of loss than its benchmark. A lower beta, on the other hand, would mean lower risk and lower profit potential. For example, if we calculate beta for the Coca-Cola Company (NYSE: KO) against Dow 30 (INDEXDJX: DJI) index and get 1.5, the stock beta would be 0.5 higher than the benchmark beta, meaning that Coca-Cola prices are 50% more volatile than Dow 30 in the same time period.

Calculating Alpha (α) and Beta (ß)

Alpha (α) = Rp – [Rf + ß(Rm – Rf)]
Beta (ß) = Covariance (Re, Rm) / Variance (Rm)

For example, we want to calculate our risk exposure when trading Microsoft stocks in Q4 and use NASDAQ 100 index as a benchmark. Let’s say in this period, 

Since we require beta to calculate alpha, we start with ß first. Let’s say, in the given period, there is a 0.9 (90%) price correlation between Microsoft and NASDAQ 100, and the price variance of NASDAQ is 1.35%. We calculate the covariance of the stock and the market, then divide to the market return, and find ß = 0.67 (67%). Next, we use ß to calculate alpha. We insert the numbers to the formula and find α = 7.97%. Interpreting our α = 7.97% and ß = 0.67 values, we conclude that in the given time period, Microsoft performed better than the benchmark NASDAQ 100 index by bringing 7.97% more risk-adjusted return and experiencing 33% less volatility.

Practical Application of Alpha and Beta

We calculate the alpha and beta values from past performances of a financial asset and a benchmark within a time period. Then, we use this information to predict a similar active and passive risk exposure in an equivalent time period in the future. Let’s say that Apple launched a new model of iPhone, and we want to know how Apple stocks would react over the next three months. We analyse the 3-month performance after previous product release to estimate the risk exposure of trading Apple stocks in the next 3 months. Using NASDAQ-100 index as a benchmark, we calculate the alpha and beta values. The alpha and beta values of the 3-month period after the previous launch inform us about the active and passive risks in the next three months. There are several ways which we can improve our alpha and beta risk analysis: averaging multiple timeframes, establishing a confidence interval, and using multiple benchmarks.

Multiple Timeframes

Above example uses only the previous product launch. To improve our estimation, we can use the last three launches. First, we calculate alpha and beta for each. Then, we find the averaged alpha and the averaged beta. However, we must consider that each period may have had different market conditions. Analysts often use weighted alpha and weighted beta calculations by assigning weights to each time period with an emphasis on the more recent one.

Confidence Interval

We can improve multiple timeframes by calculating the standard deviation (SD) of the alpha and the beta values and establish a confidence interval. Accordingly, we can suggest with 67% confidence that the result will be within one negative SD and one positive SD. Moreover, we can also suggest with 95% confidence that the result will be within two negative SD and two positive SD. For example, if we calculated alpha’s average as 4% and standard deviation as 0.5%, we can predict with 67% confidence that the alpha value of the next three months will be between 3.5% and 4.5%, and with 95% that it would be between 3% and 5%.

Mitigation: Risk Management Strategies

Now that we know how to identify and evaluate active risks that occur due to our trading strategy and the passive risks that occur due to the market conditions, we can use three main approaches to risk mitigation techniques: budget-based approaches, portfolio diversification, and hedging strategies.

Budget-Based Approaches To Risk Management

Budget-based approaches involve money management strategies. According to our resources, leverage and trading goals, we tailor a capital distribution guide which outlines how we use our funds across all investments. It includes position sizing rules, P/L ratio, price targets, and investment exit strategies. You can also use our trading calculator in order to estimate the possible outcome of a trade before entering it.

Position Sizing

Position sizing refers to the ratio of a single position size to the total capital. Successful traders adopt the 1% rule, which suggests that the size of a position should never exceed 1% of the total capital. For example, if you have $10,000 capital, the margin you allocate to a position should be less than $100. The remaining capital serves as a buffer against the floating profits and losses (P/L) and protect you from a close-out. Each asset has different risk factors and volatility levels. Thus, adjusting your position sizing strategy accordingly can establish a balance between the investment and the risk.               

P/L Ratio

P/L Ratio refers to the win rate of your closed positions. A high P/L ratio doesn’t necessarily indicate portfolio profitability as your success will depend ultimately on the actual profits. In order to understand the required P/L ratio; we should establish a reward/risk ratio (RRR). For example, if our RRR is 3:1, we need 25% win rate. However, RRR is 1:1 we would need a 50% win rate. There are many online tools to calculate the required P/L ratio based on RRR. 

Price Targets

Knowing when to exit a position is just as important as knowing when to enter it, and it can be emphasised as one of the most fundamental risk control strategies. Keeping a winning position open to accumulate profits can end up with a market reversal that erases all gains.

Similarly, leaving a losing position open, hoping an eventual market reverse, can wipe out the entire capital. Thus, as a forex risk management strategy, when we open a position, we prespecify the price targets and set take profit and stop loss orders to automatically exit the position when they are reached.

There are several technical indicators to identify price targets: 

Portfolio Diversification

Portfolio diversification is “not keeping all eggs in one basket” but choosing less-correlated assets. If the same factors affect two assets, they move simultaneously and have high correlation; if not, they wouldn’t move together and thus have no correlation. A correlation can be positive or negative. A positive correlation is when the prices are moving in the same direction; in negative correlation, they move in the opposite direction. For example, when USD increases after an economic report: 

Hedging

Hedging is a trading risk management method. It means when you open a trading position, you will open another position with the same asset in the opposite direction of your investment. If your primary position loses, your alternative position will profit and make up for the losses. AvaTrade’s Call and Put options trading, which reserves the strike price for a duration and allows you to exit the position from that price until expiry, are often used as a hedging strategy to minimise the cost of the alternative position. AvaTrade’s innovative AvaProtect tool in the AvaTradeGO mobile trading application employs specifically this approach to help you manage your risk with ease. When you trade using AvaTradeGO, you can use AvaProtect feature to open an opposite-direction option at the same time you execute the trade. This unique feature simplifies the risk management for you.

10 Rules of Risk Management

Risk management is the most important aspect of any trading plan. Apart from the mathematical and strategic methodologies to employ, there are several precautions you can adopt as a trader and consider in your decision-making process. 

Applying Risk Management Strategy

It’s time that we see the benefits of risk management with profits! Now that we learned what financial risk management is, how the risk management process works, and how can we improve our success and increase our profits by managing our risk, we can trade with confidence. Apply what you’ve learnt, then observe how your portfolio achieves a sustainable and profitable improvement. Start right away by using the AvaProtect feature and see the benefits of options-based risk management or check a risk-free demo account (aka paper trading account) to see the efficiency of the trading plan.

Main Risk Management Strategies FAQ

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