One of the key factors for successful trading on the exchange is proper risk management. Any professional trader possesses these skills at a high level, for beginners, we have prepared this article. We will help you understand the basics of risk management and save yourself from some mistakes.
The essence of risk management in the stock market
Trading on the stock market is characterized not only by the specificity of trading instruments, but also by the very organization of trading. This part of the financial market is determined by a significant share of long-term transactions and a large number of portfolio investors, as well as more conservative trading decisions. Not surprisingly, risk management in this industry is rather non-trivial.
The main factors of risk management in the stock market are:
- Position volume control
- Control of the degree of risk for each individual transaction and total position
- Application of risk limiting tools
For example, risk management when trading CFDs is related to controlling the amount and the maximum amount of risk. However, when investing in stocks, you will also have to consider all non-market risk factors.
This does not mean at all that the classical calculation of the transaction volume or the ratio of probable profit and loss are not relevant when trading securities, but in combination with them you will need additional market-specific elements and risk management strategies.
THE ELEMENTS OF THE RISK MANAGEMENT SYSTEM ARE:
- Identification and assessment of risk factors
- Selection of tools that can be applied to reduce the level of risk
- Detailing the overall strategy for risk management
- Step-by-step implementation of the developed actions
- Evaluating performance and making the necessary adjustments to the strategy
It is very important to remember that building a system does not end with using it. In order for a trader to find a successful strategy and maintain its effectiveness, he will need to analyze the results obtained and constantly improve the trading strategy.
Types of risks in the stock market
When trading on the stock market, an investor faces a considerable number of different kinds of risks. All of them, in fact, are divided into only two large groups:
- Market risks
This kind of risk is based on incorrect forecasting of the situation by the trader when opening a deal. The reason may be both an insufficient amount of analyzed information, and chaotic market movements caused by events that could not be foreseen.
One way or another, the main factor of market risk is the change in prices for a traded financial instrument.
- Non-market risks
This type of risk is due to the impact of external factors, such as changes in legislation, unfair actions of the counterparty, changes in the geopolitical arena that affect the trading process, etc.
Basically, the impact of this kind of risk cannot be predicted or calculated. That is why, it belongs to casual and is subject to insurance.
STOCK MARKET RISK MANAGEMENT TECHNIQUES
There are several basic methods to help you manage your risk:
This type of risk management is used by absolutely all competent traders. Its essence lies in the strict limitation of the quantitative limits of certain factors. For example, the introduction of limits for daily losses, the volume of losses from specific transactions, the target rate of return, or the determination of the minimum ratio of possible profits and losses. Examples of such tools are Stop Loss and Take Profit, which help limit the maximum profit and loss on a trade.
Diversification involves the distribution of cash across different assets that are not correlated with each other. Thus, you create a portfolio in which losses on one group of securities (if any) are compensated for by gains on other securities that are in no way related to the unprofitable ones. This method of risk management will help you to protect yourself from losing money under the influence of negative actions in one industry.
This method has two options: self-insurance and insurance with the participation of specialized companies. The first case involves the creation of a reserve, which is intended to cover losses. Simply put, the investor does not invest the entire amount at once, but leaves some part for unforeseen expenses. The second case is intended solely for non-market risks. The depositor deliberately refuses a certain percentage of the profit in favor of paying for the services of the insurance company.
It is carried out by insuring its losses on existing securities by opening positions in the derivatives market for derivative financial instruments. It is imperative that they have a correlation or functional relationship with the portfolio securities prices. It is assumed that in the event of a negative change in the prices of securities in the portfolio, part of the losses will compensate for the profit from the reverse-directed position in the derivative financial instrument.
Trading in securities is a rather risky way to make money if you do not follow the basic rules of risk management. The Afex Capital team advises not to expose yourself and your savings to unreasonable risks and entrust capital management to professionals.