Financial investing and market speculation carries inherited risks due to various factors such as volatility, liquidity, risks associated with particular assets, and many other factors. Managing financial risks involves identifying potential risks, assessing their impact on your investment portfolio and implementing strategies to mitigate or minimize them.
Economic factors, geopolitical events, actions of central banks, pandemics and global warming contribute to financial markets turbulence. Volatile and turbulent markets can be challenging for many, while for others it can create attractive opportunities to increase wealth.
Managing financial risks
Depending on the asset type you are trading or investing in, you might be faced with different challenges. However, basic principles to manage your risks are similar across different asset classes. Let’s take a look at ways of managing financial risks.
Assess your risks
The first stage is to make an assessment of your risks. Every asset is unique and carries a different scope of risks. Typically, the riskier the asset is, the higher the potential for rewards. Risks and rewards are different for short term speculators and long term investors. Trading Contracts for Difference (CFD) instruments are highly risky for beginners due to leverage. Leverage enables traders to increase their purchasing power by using borrowed funds from their broker. As traders get more advanced, they learn risk management strategies and increase their chances of success. There are many trading platforms that enable you to demo trade and develop trading systems. For instance, you can check the comparison of currency trading software platforms.
Set criteria for your risk to reward ratio:
Generally, active traders have 1:1 risk to reward ratio or better. Investors and medium term traders such as position traders and swing traders have much better risk to reward ratios than day traders due to the fact that they place fewer trades and their profits need to be worth the time and effort they spend on trading. Traders use Stop Loss (SL) and Take Profit (TP) levels to determine their risk/reward ratios. It’s important to take into account the probability of your predictions when setting your risk to reward ratio rules. In order to be profitable long term, there are two scenarios:
- You can use a 1:1 risk to reward ratio, but the likelihood of trade closing in profits needs to be greater than 50%.
- The likelihood of your market prediction coming true can be lower than 50%, however, your rewards per risk need to be greater than 1:1. This way your winning trades will cover for the losses and gradually increase your trading balance.
Many people have this idea that active investors and traders are great at predicting asset prices, while this is not true. The key to success for many traders is making huge profits when they are correct, that allows them to open many different losing trades and still remain in profit.
Manage your trading size
Most professional traders have simple risk management rules in place when they are making an investment decision. For example, many traders never risk more than 1-5% of their trading balance on any given trade. This way traders protect themselves from emotional trading. In addition, when you are only risking a small amount of your capital per trade, your capital is well protected. It should be mentioned that leverage plays an important role in investing. Most brokers offer customizable leverage to their clients. Choosing high leverage can be dangerous for beginner traders, however, professional day traders will find it helpful.
Diversify your investments
Diversification of investments helps traders spread their risks. However, it should be noted that it’s best for beginner traders to stick with a limited number of instruments, so that they don’t get overwhelmed by the vastness of the information they receive.
The main goal of diversification is to reduce the impact of any single investment’s performance on overall investment capital. Here are some key points to take into account when diversifying your investment portfolio:
- Asset classes: you can diversify your risks by investing in different asset classes, such as: stocks, bonds, currencies, cryptocurrencies, futures, real estate, and commodities.
- Sectors: spread your investments across different sectors or industries, such as technology, healthcare, finance, and consumer goods.
- Geographic diversification: consider investing in different countries and regions that are less correlated with each other. For example, European and British economies are highly correlated with each other due to interpersonal relationships, trade ties and economic activity. In addition, economies of some countries are highly correlated with certain commodity prices, such as Russia, Canada and the United Arab Emirates.
To sum everything up, investing in financial markets and active trading carries inherent risks. Increased volatility and turbulence can become challenging for many, however, for others, this may generate more trading opportunities. Traders can use various strategies to mitigate and reduce their risks. Firstly, it’s important to assess your risks, set risk to reward ratio, manage your trading size, and diversify your investments.