Content

  • What is risk management?

  • How does risk management work?

    • Set goals

    • Identify risks

    • Risk assessment

    • Determine how to respond

    • Monitor response effectiveness

  • Financial risk management

  • Conclude


What is risk management?

In life, we always manage risk, whether in simple tasks (like driving) or by purchasing insurance or medical care plans. In essence, risk management includes assessing and responding to risks.

Most of us manage risk unconsciously in our daily activities. But in financial markets and business administration, risk assessment is an important and conscious activity.

In economics, we can describe risk management as a model in which a certain company or investor handles financial risks, which is an inherent process of all types of businesses.

For traders and investors, this model can include managing a variety of assets, such as cryptocurrencies, forex, commodities, stocks, indices, and any other assets. movables.

There are many types of financial risk, which can be classified in different ways. This article provides an overview of the risk management process. The article also presents some strategies to help traders and investors minimize financial risks.


How does risk management work?

The risk management process usually includes five steps: setting goals, identifying risks, assessing risks, determining how to respond and monitoring. However, depending on the context, these steps may vary.

Set goals

The first step is to identify the company's main goals. It is often related to a company's or individual's risk tolerance, or how much risk the company or individual is willing to take to achieve its goals.

Identify risks

The second step includes detecting and identifying potential risks. This step aims to identify all types of events that can cause negative effects. In a business environment, this step can also provide insights not directly related to financial risk.

Risk assessment

After identifying the risks, the next step is to assess the expected frequency and severity of those risks. These risks are then ranked according to their importance, on the basis of which the company or individual can devise or apply an appropriate response.

Determine how to respond

The fourth step includes determining how to respond to each type of risk according to its importance. This step establishes the action to be taken in the event of an adverse event.

Monitor response effectiveness

The final step of a risk management strategy is to effectively monitor the methods used to respond to events. This often requires continuous data collection and analysis.


Financial risk management

There are a number of reasons why a strategy or trading setup may fail. For example, a trader may lose money because the market moves in the opposite direction of their futures position or because they get carried away by their emotions and end up selling out of panic.

Emotional reactions often cause traders to ignore or abandon their original strategies. This is especially noticeable during persistent price declines, known as bear markets, and periods of capitulation.

In the financial markets, most people agree that having a proper risk management strategy will greatly contribute to their success. In practice, this can be as simple as setting  Stop-Loss or Take-Profit orders.

An effective trading strategy needs to clearly provide actionable actions, which means traders can be prepared to deal with all situations. However, as mentioned, there are many ways to manage risk. Risk response strategies should be continually revised and adjusted.

Below are a few examples of financial risks, along with short descriptions of how people can reduce them.

  • Market Risk: Can be minimized by placing a Stop Loss order on each trade to automatically close positions before larger losses are incurred.

  • Liquidity risk: Can be minimized by trading in high volume markets. Assets with high market capitalization tend to be more liquid.

  • Credit risk: Credit risk can be reduced by trading through a trusted exchange so that both borrower and lender (or buyer and seller) can transact trustlessly. think of each other.

  • Operational Risk:  Investors can minimize operational risk by diversifying their portfolio, preventing exposure to just a single project or company. They can also do some research to find companies that are less likely to experience operational problems.

  • Systematic risk:  Can also be reduced by diversifying the investment portfolio. But in this case, it is advisable to diversify by including projects with separate proposals or companies from different industries. It's best to choose projects or proposals that have very low relevance.


Conclude

Before opening a trading position or allocating capital to a portfolio, traders and investors should consider creating a risk management strategy. However, it is important to remember that financial risk cannot be completely avoided.

Overall, risk management defines how to respond to risks, but certainly not only to minimize risks. Risk management also includes strategic thinking so that inevitable risks can be handled in the most effective way possible.

In other words, risk management is also about identifying, assessing and monitoring risks, depending on the context and strategy. The goal of the risk management process is to evaluate the risk/reward ratio to prioritize the most profitable trading positions.