Risk management is a process of identifying, assessing, or mitigating uncertainties in investment decisions. In other words, the idea is to protect the traders or investors from losing all their money. The risk occurs when traders experience loss in their investments, but if it is managed, traders can fearlessly explore the markets to make money.
Identification of risks:
To identify trading risks and to imply risk management, one must know different variables existing in the market. These variables include economic factors such as interest rates by central banks or a trade war in the market. While identifying economic factors it is important to consider those variables that can affect the price of assets. If the factors are powerful enough to influence prices, then we must know the frequency of these factors.
Finding out these crucial frequency points can help us with identifying whether these factors are a potential threat to the portfolio or not. It will further help in handling the risky situations in the market by implementing practices such as diversification of assets, hedging, investing in options into high risk and low risk etc.
Evaluation of trading risks:
The trading risk evaluation means studying the performance of the portfolio in the market. In the market, there are two ways to evaluate risks – Alpha and Beta.
Alpha is used to measure the investment’s performance compared to a certain benchmark. If alpha is positive, it means it has performed well against the benchmark. But if it is negative, it indicates that the portfolio has underperformed.
Beta is used to determine how volatile a portfolio or security is compared to the market as a whole. If the beta is more than 1 it implies that the security or portfolio is more volatile than the market. Similarly, if it’s less than 1 it implies the investment is less volatile.
Risk management strategies:
There are some popular risk management strategies that help in making trades successful while eliminating the risk such as:
- Portfolio Diversification
- Hedging
- 1% rule and 2% investing rule
Portfolio Diversification:
Portfolio optimization is a process of building portfolios to maximize expected returns while keeping the risk minimized. In this, the portfolio is analyzed with different proportions of investments by calculating each portfolio’s risk and return and selecting the most desired mix of investments that can achieve greater return with minimum risk which is one of the most common risk management solutions among traders.
Hedging:
This strategy is designed to offset a potential loss. In other words, hedging is used to invest to reduce the risk. The idea is to protect the portfolio from adverse price movements by attaining a price lock. It is done by offsetting contracts against the natural position held by the investor while hedging against credit risk. Hedging can be simply done for risk management by using derivatives or other financial instruments like swaps, futures contracts, insurance, options, etc.
1% rule and 2% investing rule:
1% and 2% rules in trading denote that the maximum risk amounts per trade should be either 1% or 2%. Hence, capital of more than 1% or 2% should not be risked on a single trade. The aim is to help investors to avoid excessive losses that may happen otherwise. For instance, a trader holding $1000 of capital would not risk more than $10 on a single trade. This rule is most feasible for day traders.
Conclusion:
In trading, it is important to ensure that the traders are secure with the right risk management strategies. Having a good knowledge about the potential risks and practices to avoid them is a boon for any trader as it helps in maximizing gains and minimizing losses.
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