Content

  • What is risk management?

  • How does risk management work?

    • Identification of risk objects

    • Risk identification

    • Risk assessment

    • Definition of strategy

    • Monitoring

  • Financial Risk Management

  • In conclusion


What is risk management?

We constantly manage risks in life, whether it's while performing simple tasks (like driving a car), applying for insurance, or planning treatment. At its core, risk management is the story of assessing and responding to risks.

When performing routine actions, we manage them unconsciously. But when it comes to financial markets and business management, risk assessment is a key conscious practice.

In economics, we can describe risk management as a system of rules that determine how a company or investor handles the financial risks inherent in all types of business.

For traders and investors, this system can include management of multiple asset classes such as  cryptocurrencies, Forex, commodities, stocks, indices and real estate.

There are many types of  financial risks that can be classified in different ways. This article provides an overview of the risk management process. It also presents some strategies that can help traders and investors reduce these risks.


How does risk management work?

Typically, risk management involves five steps: risk identification, risk identification, risk assessment, strategy definition, and monitoring. Depending on the context, the steps may vary significantly.

Identification of risk objects

The first step is to identify your main goals. They are often related to the risk attitude of a company or individual. In other words, how much risk are they willing to take to achieve their goals?

Risk identification

The second step is to identify and identify potential risks. The goal is to list all events that could cause negative impacts. In business, this step may also involve in-depth analysis that is not directly related to financial risks.

Risk assessment

After identifying risks, the next step is to assess their potential frequency and severity. Risks are ranked in order of importance, thereby guiding the development and adoption of appropriate responses.

Definition of strategy

The fourth step is to determine the response to each type of risk according to its level of importance. At this stage, the measures necessary to be taken in the event of a risk realization are determined.

Monitoring

The fifth step of a risk management strategy is to track the effectiveness of responses to events. Continuous data collection and analysis is often required.


Financial Risk Management

There are several reasons why a strategy or trading setup may fail. For example, a trader may lose money because the market moves against a futures contract position or because players get emotional and sell assets out of panic.

Emotional reactions often cause traders to deviate from their original strategy. This is especially noticeable during periods of bear markets and periods of capitulation.

Most financial market participants agree that having a proper risk management strategy makes a significant contribution to their success. In practice, this can be as simple as setting up Stop-Loss or Take-Profit orders.

A sound trading strategy should provide a clear pool of possible moves, meaning the trader will be more prepared for all possible situations. As mentioned, there are many ways to manage risk. Ideally, the strategy should be continuously reviewed and adapted to market conditions.

Below are a few examples of financial risks, along with a summary of steps to mitigate them.

  • Market Risk:  Can be minimized by creating a Stop-Loss order on each trade so that positions are automatically closed before incurring large losses.

  • Liquidity Risk: Can be mitigated by trading in highly active markets. Assets with high market capitalization tend to have greater liquidity.

  • Credit risk: Can be reduced by trading on trusted exchanges, so that borrowers and lenders (or buyers and sellers) do not have to directly ascertain each other's good faith.

  • Operational risk: Investors can reduce operational risks through portfolio diversification, which reduces the negative consequences of the activities of a project or company. They can also conduct market analysis to find companies less susceptible to disruptions.

  • Systemic risk: Can also be reduced by portfolio diversification. But in this case, diversification should include projects with different products or companies from different fields of activity. Those with very low correlation are preferred.


Conclusion

Before opening a trading position or committing capital to a portfolio, traders and investors should consider a risk management strategy. At the same time, it is necessary to understand that financial risks cannot be completely eliminated.

Risk management is not just about how to reduce them. It also involves strategic thinking so that inevitable risks can be exploited in the most effective way.

In other words, risk management is the identification, assessment and monitoring of risks according to context and strategy. The purpose of risk management is to assess the risk-benefit ratio to determine the most profitable positions.