Content

  • What is risk management?

  • How does risk management work?

    • Goal Setting

    • Risk identification

    • risk assessment

    • Definition of answers

    • Monitoring

  • Financial risk management

  • Final thoughts


What is risk management?

In our lives, we find ourselves constantly managing risks – whether when performing simple tasks like driving a car, or when making a new insurance or medical plan. Risk management is, at its core, a matter of assessing and reacting to risks.

Most of us manage these risks unconsciously when carrying out our daily activities. However, when it comes to financial markets and business administration, risk assessment becomes a crucial and fully conscious practice.

In economics, we can describe risk management as the framework that defines the way in which a company or investor manages financial risks - which are inherent to all types of businesses.

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

There are many types of financial risks, which can be classified in different ways. This article provides an overview of the risk management process, while presenting some strategies that can help traders and investors mitigate financial risks.


How does risk management work?

Typically, the risk management process consists of five steps: setting objectives, identifying risks, assessing risks, defining responses, and monitoring. Depending on the context, however, these steps may be significantly altered.

Goal Setting

The first step is to define what the main objectives are, which is often related to the risk tolerance of the company or individual - or put another way, the level of risk they are willing to take to move towards their goals. goals.

Risk identification

The second step involves detecting and defining what the potential risks are. The objective is to highlight all types of events that can cause negative effects. In a business context, such a step can also provide detailed information that is not directly related to financial risks.

risk assessment

After defining the risks, the next step is to evaluate their likely frequency and severity. The risks are then ranked in order of importance, facilitating the development or adoption of an appropriate response.

Definition of answers

The fourth step consists of defining responses for each type of risk, according to its level of importance. It is the step responsible for determining what action should be carried out in the event that an unfavorable event occurs.

Supervision

The final step of a risk management strategy is to monitor its efficiency in response to events. This often requires ongoing data collection and analysis.


Manage financial risks

There are several reasons why a strategy or trading setup may not be successful. For example, a trader may lose money because the market moves against their futures contract position or because they get excited and end up panic selling.

Emotional reactions often cause traders to ignore or abandon their initial strategy. This is particularly notable during bear markets and periods of capitulation.

In the financial markets, most people agree that having a proper risk management strategy drastically contributes to your success. In practice, this could be as simple as setting Stop-Loss or Take-Profit orders.

A solid trading strategy should provide a clear set of possible actions, meaning traders can be more prepared to deal with all types of situations. However, as mentioned, there are numerous ways to manage risks. Ideally, strategies should be continually reviewed and adapted.

Below are some examples of financial risks, along with a brief description of how people can mitigate them.

  • Market risk: It can be minimized by setting Stop-Loss orders on each trade so that positions are automatically closed before incurring further losses.

  • Liquidity risk: can be mitigated by trading in high volume markets. Generally, assets with a high market capitalization value tend to be more liquid.

  • Credit risk: It can be reduced by trading through a trusted exchange so that borrowers and lenders (or buyers and sellers) do not need to trust each other.

  • Operational risk: Investors can mitigate operational risks by diversifying their portfolio, avoiding exposure to a single project or company. They can also do some research to find companies that are less likely to experience operational failures.

  • Systemic risk: can also be reduced through portfolio diversification. But in this case, diversification should involve projects with different proposals or companies from different industries. Preferably those that have a very low correlation.


In conclusion

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

In general, risk management defines how to manage risks, but it is certainly not just about mitigating them. It also involves strategic thinking so that inevitable risks can be taken as efficiently as possible.

In other words, it is also about identifying, evaluating and monitoring risks, according to the context and strategy. The risk management process aims to evaluate the risk/reward ratio so that the most favorable positions can be prioritized.