Financial risk
The chance of an investment's actual return being different than expected. Trading the financial markets is, effectively, the trading of risk.
Module 05
Risk Management
Before any strategy, before any indicator — define risk, understand what amplifies it, and learn the small set of rules that keep traders in the game.
First things first
What does "risk" actually mean?
Let's not get ahead of ourselves. Before talking about how to manage risk, make sure you understand what risk truly is.
Risk is uncertainty — the chance of an outcome being different than expected.
Example
By buying EUR/USD you effectively believe the Euro will strengthen against the US Dollar. The risk is the possibility of the opposite — the Euro weakening — an adverse move.
Financial risk is the possibility of losing part or all of your original investment.
Risk = opportunity
Why would we "risk" the market going against us?
Although risk makes you susceptible to adverse moves, risk is also what creates the opportunity for sizeable returns. No risk, no reward.
The risk / reward trade-off
The higher the risk an investor takes on, the higher the potential return must be to compensate for it.
Low risk → Low return
High risk → High return
What makes trading risky?
Three forces that amplify risk.
Several factors influence how much risk a trade carries. Three matter more than any others.
01 — Leverage Leverage
Higher leverage = more risk = larger profit potential.
Leverage lets you control a relatively large position for a fraction of its cost — magnifying both profit and loss. A 0.25% margin requirement, for example, is 400× leverage: $250 controls $100,000 in market exposure.
02 — Volatility Volatility
Higher volatility = more risk = larger profit potential.
Volatility is the size of price changes over time. High volatility means prices can swing dramatically in either direction over short periods — opportunity and danger in equal measure.
03 — Trading psychology Trading psychology
Emotion is the most underestimated source of risk.
Trading is far more emotional than it looks. Fear and greed inflate implied volatility, hope keeps you in losing trades, and a bad mental state distorts every decision. Covered in depth in the next module.
Risk management tools
Stop loss orders.
Stop loss orders are the single most important risk management tool — and should always be in place when trading.
Breakeven stops
Executed at the point where gains equal losses — locking in a no-loss outcome on a trade that has moved in your favour.
Time stops
Rely on a certain period of time elapsing before the order is executed — useful when a thesis hasn't played out within its expected window.
Trailing stops
Set at a percentage below the market price and ratchet with it. They let profits run while quietly capping the downside.
Learn to love your losses, manage your losses, and learn from your losses — or one day a loss will wipe out your entire account.
Risk and return
Lower risk, lower potential. Higher risk, higher potential.
Your trading style will define how low or high risk your strategy is — but even the greatest strategy is of little help if you don't control risk.
Low risk
Potential low return.
Medium risk
Potential medium return.
High risk
Potential high return.
How tough are you?
Know your risk tolerance.
Risk tolerance is the degree of uncertainty you can handle about a potential loss or decrease in your portfolio. It differs from person to person and generally depends on three things.
01 — Income Income
Your personal income and situation. A person on a low salary about to get married will typically have a lower risk appetite than a single person on a medium salary.
02 — Time horizon Time horizon
How long you plan to keep your money invested. Longer time horizons are associated with less risk than shorter ones.
03 — Investment objectives Investment objectives
The greater your financial goals, the greater the risk you will likely need to take on to reach them.
Asset allocation
Balance risk and reward.
Asset allocation is an investment strategy that shares your portfolio between asset types according to your goals, risk tolerance and time horizon. Different allocations carry different levels of risk.
Diversification
Spread risk across uncorrelated assets.
A risk management technique that reduces risk by mixing many different investments. It is particularly useful against unsystematic risk — the industry- or company-specific kind.
The lower the correlation between investments, the lower the risk overall — bad performers can be offset by good ones.
Gold and the US Dollar
Gold is inversely correlated to the dollar — as the dollar weakens, the value of gold tends to appreciate.
Gold and Crude Oil
Rising crude oil prices tend to lift gold, as gold is often bought as a hedge against the inflation oil prices imply.
Controlling your leverage
Match leverage to your risk appetite.
Leverage can be tailored. If you're risk averse, trade on higher margin requirements to reduce leverage. Treat margin like a credit card — don't get carried away with money you don't have.
| Margin requirement | Leverage | Risk level |
|---|---|---|
| 0.5% | ×200 | High risk |
| 1% | ×100 | — |
| 3% | ×33.3 | — |
| 10% | ×10 | — |
| 20% | ×5 | — |
| 50% | ×2 | — |
| 100% | No leverage | Low risk |
An ally — Technical analysis
Technical analysis is risk management.
Use it to time entries and exits, identify support and resistance, place strategic stop losses, spot trends and patterns, and build risk parameters from indicators. All of this lowers risk and improves your chances of profit.
- Identify and time entry / exit points.
- Identify support and resistance.
- Place strategic stop loss orders.
- Identify trends and chart patterns.
- Create risk parameters from indicators.
Volatile markets
Four golden rules when conditions get rough.
01 Use stop losses
A stop loss — a preset level that closes a trade automatically — limits downside and reinforces discipline. In very volatile markets be aware of slippage and gaps: the first available price after a gap can be well past your stop, sometimes producing a loss larger than the initial deposit.
02 Reduce your trade size
Margin is one of the great advantages of CFD trading, but every margin trade should consider how much capital sustains the position. A common rule: no single position should risk more than 5% of available capital. In volatile conditions, halve your normal size.
03 Limit your trades
Volatile markets mean high volumes and possible execution delays. Spreads may widen and some market makers temporarily withdraw prices. In high-volatility windows it is sometimes better to limit trade execution altogether.
04 Stick to your strategy
In volatile periods it's easy to be shaken from a strategy that works in calm ones. Experienced traders apply the same investment process they normally do — short-term moves are nearly impossible to predict; long-term discipline isn't.
Key takeaways
The important bits.
- Risk management exists to control losses.
- Always know your risk tolerance.
- Build a risk management strategy — leverage, volatility, diversification, asset allocation.
- Make a stop loss strategy part of it.
- Be disciplined in executing your strategy.
Plan your work and work your plan.
