Types of Risk in Trading and Risk Management Strategies

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Trading in the financial markets brings multiple opportunities and involves certain risks. When a trader knows what can influence asset prices and how to deal with it, their results and overall performance are likely to be better. Employing effective risk management strategies, in addition to general awareness, will help reduce potential losses. This FXOpen article looks at the different types of risks and trading risk management strategies.

Types of Risk in Trading

Professional traders incorporate risk management techniques to keep losses from spiralling out of control. But before we move on to how to minimise risks, let’s identify them. This section explores some major types of risks in trading.

Market Risk

Market risk is the possibility of losing money due to unfavourable movements in market prices. So, what may happen?

  • The price of an asset could move in the opposite direction to your forecast.
  • The price of an asset could fluctuate widely.
  • The stop-loss may not be executed quickly enough to prevent a loss.
  • The price of an asset could experience a gap, meaning it may open at a price that significantly differs from the previous day’s close.

Counterparty Risk

Credit risk in forex trading is primarily associated with the risk of a counterparty, such as a broker or financial institution, failing to fulfil its financial obligations. For example, if you have a trading account with a broker and they become insolvent or fail to honour a withdrawal request, you face credit risk.

Leverage Risk

There’s the risk of significant losses due to the use of leverage. It is associated with trading on margin, which amplifies both potential profits and losses. With high leverage, the chance that the position will close quicker if the market moves against the trader is higher.

Operational Risk

This is caused by any failures in operational processes. To illustrate this, let’s consider three examples.

  • An order may not be executed as intended, with errors or delays.
  • A technology system may malfunction.
  • A trader or broker may fail to comply with the regulator's requirements, resulting in an abrupt termination of all operations.

Event Risk

Unexpected or unforeseen events usually have a huge impact on financial markets. For example, a natural disaster or a terrorist attack could even cause a market to crash. The same could be applied to economic data releases.

Country Risk

Political or economic instability in a particular country could trigger a large-scale sell-off of assets, for example, a domestic currency. This category also includes changes in government fiscal policy, interest rates, and regulations. These changes may lead to the massive sale of some high-risk assets and the purchase of safe-haven alternatives.

Psychological Risk

Emotional or cognitive biases may lead to losses even if a trader has a sound strategy. The theory states that all irrational decisions should be avoided, and it’s of paramount importance to stick to a well-developed trading plan.

Market Risk Management Strategies

Managing risk in trading is not overly tedious, but it requires time and attention. Also, never say that you don’t have time for planning and risk management. According to trading experts, one should not even start without it. Here are some strategies that traders can use to manage market risk.

  • Position sizing involves determining the appropriate size of a trade based on your risk tolerance and the size of your trading account.
  • Stop-loss and take-profit orders automatically close a trade when the price reaches a certain level. They can help protect your capital and lock in profits.
  • Risk-reward ratios are used to determine the potential reward of a trade relative to the potential risk. Usually, traders implement 1:2 and 1:3 ratios.
  • Diversification refers to spreading investments across different assets. At FXOpen, you can trade a wide range of pairs as well as index, stock, commodity, and crypto* CFDs to diversify your portfolio.
  • Correlation analysis involves analysing the relationship between different assets in your portfolio to avoid overexposure to similar risks.
  • Stress testing your strategy means subjecting it to various scenarios to explore its robustness and validate its performance before it is put into use. This helps traders prepare for adverse market conditions.

Managing Counterparty Influence

As was mentioned, a trader can suffer losses due to the failure of a counterparty to meet its obligations. Counterparty due diligence involves researching potential counterparties to ensure that they are reliable and trustworthy. This can be done by checking their creditworthiness, financial stability, and reputation. In addition, using regulated brokers and clearinghouses can also help reduce this risk.

Decreasing Leverage

Reducing leverage can help decrease the likelihood of incurring losses. Consider using risk-adjusted position sizing to determine the appropriate size of a trade based on the level of leverage used. Try not to overuse leverage, as it’s risky.

Minimising Operational Risks

While double-checking orders can help reduce the number of human errors when entering the data, having a robust trading infrastructure decreases the possibility of technology failures. Traders can use the TickTrader platform to have access to the best quotes and effective trade execution.

Following Local and Global News

Staying informed about global events helps traders anticipate potential risks. The theory states that it’s best to start your day by monitoring global events and news that could impact your trading decisions. Additionally, you can use currency hedging strategies to mitigate the effects of news-based exchange rate fluctuations. You can check the most recent market updates and analysis on the FXOpen blog.

Managing Emotions

Emotions like fear, greed, and anxiety can cloud judgement and lead to impulsive decisions. To avoid this, you can create a well-thought-out trading plan that includes entry and exit strategies, risk management rules, and predefined goals. What’s more, you can maintain a detailed trading journal to record every trade, including the rationale behind each decision. This usually brings peace of mind.

Final Thoughts

Trading and risk management are interconnected. Understanding and effectively managing it is critical. By applying appropriate strategies, traders can protect their capital and increase their chances of achieving their trading goals. Remember, no strategy can completely eliminate risk, but a well-thought-out and disciplined approach can help you confidently navigate the challenges of trading. If you want to start trading, you can open an FXOpen account. Happy trading!

*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.