What is risk management?
We manage risk throughout our lives, whether it's performing simple tasks (like driving a car) or setting up new insurance or health plans. Essentially, risk management is about assessing risks and responding to them.
Most of us unconsciously manage them in our daily activities. But when it comes to financial markets and business administration, risk assessment is an important and very conscious practice.
In economics, we can describe risk management as a framework that determines how a company or investor deals with the financial risks inherent in all types of business.
For traders and investors, the framework 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 financial risks.
How does risk management work?
As a rule, the risk management process includes five stages: setting goals, identifying risks, assessing risks, determining response measures, and monitoring. However, depending on the context, these steps can change significantly.
Setting goals
The first step is to define the main goals. This is often related to the risk tolerance of a company or an individual. In other words, what risk are they willing to take to move towards their goals.
Identification of risks
The second step involves identifying and defining potential risks. It is aimed at identifying various events that can cause negative consequences. In a business environment, this step can also provide useful information that is not directly related to financial risks.
Risk assessment
The next step after identifying risks is to assess their expected frequency and severity. Risks are then ranked in order of importance, making it easier to design and implement appropriate response measures.
Determination of answers
The fourth step is to define response measures for each type of risk according to their levels of importance. It establishes the actions to be taken in the event of an adverse event.
Monitoring
The final step of a risk management strategy is to monitor its effectiveness in response to events. This often requires continuous data collection and analysis.
Financial risk management
There are several reasons why a trading strategy or technique may fail. For example, a trader may lose money because the market moves against his futures position or because he becomes emotional and ends up selling in a panic.
Emotional reactions often cause traders to ignore or abandon their original strategy. This is especially noticeable during bear markets and periods of surrender.
In the financial markets, most people agree that a proper risk management strategy contributes greatly to their success. In practice, it can simply be setting stop-loss and take-profit orders.
A sound trading strategy should provide a clear set of possible actions, which means that traders can be more prepared for any situation. However, as mentioned, there are many ways to manage risk. Ideally, strategies should be constantly reviewed and adapted.
Below are some examples of financial risks and a brief description of how people can reduce them.
Market risk: This can be minimized by setting stop-loss orders for each trade so that positions are automatically closed before they incur large losses.
Liquidity risk: it can be reduced by trading in markets with higher volumes. Typically, assets with a high market capitalization are more liquid.
Credit risk: This 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 reduce operational risks by diversifying their portfolios. They can also conduct research to find companies that are less likely to experience operational disruptions.
Systemic risk: can also be reduced through portfolio diversification. But in this case, diversification should include projects with clear proposals or companies from different industries. Preferably those that have a very low correlation.
General risk management strategies
There is no one-size-fits-all approach to risk management. Investors and traders often use a combination of risk management tools and strategies to increase their chances of growth in their portfolios. Below are some examples of strategies that traders use to reduce risk.
the 1% rule
The 1% Rule (or 1% Risk Rule) is a method traders use to limit their losses to a maximum of 1% of their trading capital per trade. This means they can trade either 1% of their portfolio per trade or a larger order with a stop loss equal to 1% of their portfolio value. The 1% rule is commonly used by day traders, but can also be adopted by swing traders.
While 1% is a general rule of thumb, some traders adjust this value based on other factors such as account size and individual risk appetite. For example, someone with a large account and a conservative risk appetite can limit their exposure per trade to an even smaller percentage.
Stop loss and take profit orders
Stop-loss orders allow traders to limit losses when a trade goes wrong. Take profit orders guarantee that they will lock in a profit when the trade goes well. Ideally, stop-loss and take-profit prices should be determined before entering a position, and orders should be set as soon as the trade is opened.
It is very important to know when to cut your losses, especially in a volatile market where prices can fall quickly. Planning an exit strategy also prevents wrong decisions due to emotional trading. Stop-loss and take-profit levels are also important in calculating the risk-reward ratio for each trade.
Hedging
Hedging is another strategy that traders and investors use to reduce financial risks. It consists of accepting two positions that compensate each other. Simply put, traders can hedge one trade by placing an opposite trade of the same size.
Opening positions in opposite directions may seem counterintuitive, but if done correctly, hedging can reduce market exposure. For example, imagine you have a long position in BTC and you keep the coins in your personal wallet. If the market is in a downtrend, you can open a short position to offset your long position without moving your BTC. This is what we call a market neutral strategy.
If you trade futures, you can trade in hedge mode on Binance Futures to simultaneously hold both long and short positions in one contract.
Diversification
As the old saying goes, "don't put all your eggs in one basket." That is, diversify your portfolio. In theory, a well-diversified portfolio provides better protection against large losses than a portfolio consisting of only a single asset. If you hold a crypto asset in a diversified portfolio, the maximum loss you will suffer if its price falls is a percentage of your portfolio. Conversely, if your portfolio consists entirely of one asset, you could lose 100% of the value of your portfolio.
Risk to reward ratio
The risk-to-reward ratio calculates the risk a trader will take in relation to the potential reward. To calculate the risk-to-reward ratio of the trade you're considering, simply divide the potential loss by the potential profit. So if your stop loss is set at 5% and your target is 15% profit, your risk to reward ratio will be 1:3, which means that the potential profit is three times the risk.
Results
Before opening a trade or placing capital in a portfolio, traders and investors should consider creating a risk management strategy. However, it is important to remember that it is impossible to avoid financial risks.
In general, risk management determines how to deal with risks, but of course it is not only about avoiding risks altogether. It also means thinking strategically so that the inevitable risks can be taken on in the most efficient way.
That is, it is also about identifying, assessing and monitoring risks in accordance with the context and strategy. The risk management process aims to assess the risk-to-reward ratio so that the most profitable positions can be prioritized.