What is risk management?

Risk management is the identification, analysis, evaluation, and management of risks when trading in financial markets. The main goal of risk management is to preserve capital and achieve stable trading results. The proper use of risk management strategies helps investors to make more informed investment decisions, which creates conditions for minimising financial losses.

Types of risks

  • Market risks. These include the risks of market downturns, increased price volatility, reduced market liquidity, rising inflation, and changing interest rates
  • Foreign exchange risks. These are the risks of sharp and considerable changes in a currency exchange rate when trading stocks and other financial instruments quoted in foreign currencies
  • Operating risks. These include risks of company mismanagement, changing market competition, and significant technological changes

Risk management strategies

  • Use of Stop Loss. This refers to preliminarily set price levels, at which the asset will be automatically sold. This helps limit losses in case of a sharp price decline
  • Portfolio diversification. The use of a variety of stocks and other financial instruments in the portfolio
  • Portfolio rebalancing. Regular adjustment of the portfolio holdings to ensure they align with the previously determined investment objectives
  • Use of options and futures. Such instruments can protect investments against risks of possible adverse fluctuations in prices and exchange rates and against reduced liquidity

An example of applying one of the risk management strategies

Let’s suppose an investor has 10,000 USD of trading capital. He has set the level of risk he is prepared to accept per transaction at 2% of the capital amount.

  • 10,000 USD * 2% = 200 USD

The investor is interested in buying Apple Inc. (NASDAQ: APPL) stock at 180 USD per share. He tries to figure out how many shares of this company he can buy, taking into consideration the risk level he had previously determined for himself, and a Stop Loss accounting for 20% of the asset purchase price.

  • 180 USD * 20% = 36 USD

The formula for calculating a position amount = Risk amount / Stop Loss amount

  • 200 USD / 36 USD = 5.5 shares

Risk management stages

  • Defining and classifying risks of investing in financial assets
  • Analysing the probability of potential risks
  • Evaluating the degree of risk impact on the investment portfolio
  • Creating action strategies to protect investments
  • Implementing the developed strategy
  • Monitoring risks and assessing the efficiency of the management measures taken