Risk management is one crucial factor in trading to ensure profits and minimise losses. Various instruments carry different levels of risk, and there are many investment strategies to manage and mitigate said risks. All that said, the first step of a risk management strategy starts with the identification and assessment of risk. More than one risk can be associated with trades, and each can influence the returns differently. A prudent trader must understand all the different risks and learn how to accurately evaluate them.
Join us as we take a quick course on risk assessment in trading and build a strong foundation for all your future trades.
Understanding Risk Assessment in Trading
Risk assessment refers to the process of evaluating the level or factors of risk present in the investment portfolio and the potential for losses. This process involves studying different factors that can have a negative impact on the trades and their prices. The findings allow traders to assess the probability and magnitude of losses. Risk assessment is an essential analysis to perform in order to make adequate and successful risk management strategies.
Types of Risks: How to Identify Them
There are five key types of risks that traders must assess and plan for:
Market Risk
Market risk is detected when the price of the trade falls as a result of market instability. For example, when you invest in the shares of a company and the stock market is in turmoil, your shares can lose value as well. There may be several causes for this, such as economic downturns, political instability, or natural disasters.
Credit Risk
Credit risk is detected when the borrower, like the government or a company, does not pay back the debt, i.e., capital invested by traders. A simple example can be lending money to a family member for their new business. If the business does not take off, the family member will not have any capital to pay you back. In trading, the risk of losing capital is due to the entity you are trading with getting into financial trouble and defaulting on payments.
Liquidity Risk
Liquidity is the ease of selling or buying a stock; therefore, liquidity risk is detected when an investment can’t be sold without accumulating losses. For instance, if you own shares in a small company with no such reputation in the market, you may find it difficult to sell your investment, as there might be limited demand. Sales in such cases can result in a loss.
Operational Risk
Operational risk is detected when the respective company has internal issues, which can be management inefficiencies, technical breakdowns, legal conflicts, cyber-attacks, or anything else, and these issues hit the share price. For example, if a company finds itself in some legal disputes, its price can drop, impacting your potential profit.
Systemic Risk
Systemic risk is detected when the complete financial markets take the hit and not just one or two companies. A massive financial crisis can lead to a general market drop. The pandemic of 2020 is the latest example of systemic risk. It impacted multiple sectors, which resulted in a GDP contraction, financial market volatility, and stress on the banking system.
Tools and Metrics to Assess Risk Levels
Here are some strategic ways to assess the risk levels when trading:
Standard Deviation
Standard deviation measures how much asset prices fluctuate from their average value, thus determining market volatility. A high standard deviation indicates extreme price fluctuations, indicating a greater investment risk. A low standard deviation indicates price stability, which is a lower investment risk level.
Sharpe ratio
Sharpe ratio evaluates risk-adjusted performance by dividing the excess returns of a portfolio by a measure of its volatility. A higher ratio indicates better performance, indicating more return against the risk taken, while a low ratio means the return does not justify the risk.
Beta
Consider beta as a return amplifier. It refers to the sensitivity of an asset to the overall volatility of the market. For insurance, a 2.5 beta indicates the potential of the respective security moving an average of 2.5 times in the market to the upside and downside.
VaR (Value at Risk)
VaR helps quantify the potential losses. It is a common risk management metric that measures the risk of loss present in any normal market condition over a specified time period, which is often 1 day.
