Contents

  • What is risk management?

  • How does risk management work?

    • Setting goals

    • hazard identification

    • risk assessment

    • Select responses

    • Monitoring

  • Financial risk management

  • Concluding thoughts


What is risk management?

We constantly manage risks throughout our working lives either while performing simple tasks (such as driving a car) or when taking out new insurance or applying for medical plans. Fundamentally, risk management is about assessing and responding to risks.

Most of us unconsciously manage risks during our daily activities. But when it comes to financial markets and business management, risk assessment is a very important and conscious exercise.

We may describe risk management in economics as the framework that determines how a company or investor deals with the financial risks that are inherent in all types of businesses.

As for traders and investors, the framework may include 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. It also offers some strategies that can help traders and investors mitigate financial risks.


How does risk management work?

The risk management process typically includes five steps: setting goals, identifying risks, assessing risks, determining responses, and monitoring. These steps may change significantly depending on the context.

Setting goals

The first step is to determine what the main goals are. They are often related to a company's or individual's risk tolerance. In other words, how much risk are they willing to take in order to achieve their goals.

hazard identification

The second step involves discovering and identifying potential risks. This step aims to detect all types of events that may have negative effects. This step may also provide business insight not directly related to financial risk.

risk assessment

The next step after identifying risks is to evaluate their expected frequency and severity. The risks are then ranked in order of importance, which may facilitate the creation or adoption of an appropriate response to these risks.

Select responses

The fourth step is to determine the responses or answers for each type of risk according to its level of importance. This step determines the appropriate action to be taken if an adverse event occurs.

Monitoring

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


Financial risk management

There are many reasons why a trading strategy or method may fail. For example a trader can lose money because the market moves against their futures position or because they become emotional and end up selling out of panic.

Emotional reactions often cause traders to ignore or abandon their initial strategy. This is especially noticeable during bear markets (Bear Markets) and capitulation (Capitulation) periods.

Most people in the financial markets agree that having a proper risk management strategy contributes greatly to their success. In practice this may be as simple as setting up stop-loss or take-profit orders.

A strong trading strategy should provide a clear set of possible actions which means traders can be better prepared to deal with all types of situations they may encounter. As mentioned before, there are many ways to manage risk. Ideally strategies should be constantly reviewed and adapted.

Below are some examples of financial risks as well as a brief description of how these risks can be mitigated.

  • Market Risk: This risk can be mitigated by placing stop loss orders on each trade so that positions are automatically closed before larger losses are incurred.

  • Liquidity Risk: Can be mitigated by trading in markets with high trading volume. Assets with a higher market capitalization are usually more liquid.

  • Credit Risk: Can be mitigated by trading through a trustworthy trading platform so that borrowers and lenders (or buyers and sellers) do not need to trust each other.

  • Operational Risk: Investors can mitigate operational risk by diversifying the assets in their portfolio, eliminating exposure to a single project or company. They may also do some research to find companies that are less likely to face the risk of operational failures.

  • Systematic risk: can also be mitigated by diversifying portfolio assets. But in this case diversification should include projects with distinct proposals or companies from different industries, preferably those that show very low correlation.


Concluding thoughts

Traders and investors should consider developing a risk management strategy before opening a trading position or allocating capital to a portfolio. It is also important to keep in mind that financial risks cannot be completely avoided.

Risk management defines how risks are dealt with in general, but it is certainly not just about mitigating these risks. It also involves strategic thinking so that inevitable risks can be dealt with in the most effective way possible.

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