Contents

  • What is risk management?

  • How does risk management work?

    • Set a goal

    • Identify risks

    • Risk assessment

    • Identifying reactions

    • To follow

  • Management of financial risks

  • latest ideas


What is risk management?

We constantly manage risk throughout our lives. We use it for simple actions like driving a car or more complex processes like creating a new insurance plan or medical plan. At its core, risk management involves identifying and responding to risks.

Many of us manage these risks subconsciously during daily activities. However, when it comes to financial markets and business management, risk assessment becomes a very important and conscious practice.

We can define risk management in economics as a general framework that determines how a company or investor manages the financial risks inherent in any business.

For traders and investors, this framework can include the management of multiple asset classes such as cryptocurrencies, Forex, commodities, stocks, indices, and real estate.

There are many different types of financial risks, and they can be grouped in different ways. This article provides an overview of the risk management process. It also lays out some strategies to help traders and investors avoid financial risks.


How does risk management work?

The risk management process generally consists of five steps: setting goals, identifying risks, assessing risks, determining responses, and tracking. But in different contexts these steps can vary greatly.

goal setting

The first step is to determine what the main goals are. This often relates to the risk tolerance of the company or individual. In other words, it includes how much risk they are willing to take to achieve their goals.

Identifying risks

The second step is to identify and define what the potential risks are. This step aims to uncover any events that will have a negative impact. In business, this step also provides insightful information that is not directly linked to financial risks.

Risk assessment

Once risks have been identified, the next step is to evaluate the estimated incidence and severity of these risks. The risks are then ranked in order of importance. This makes it easier to create or adopt appropriate responses.

Identifying reactions

The fourth step consists of determining responses for each type of risk based on their level of severity. It is determined what to do if a negative situation arises.

Following

The final step of the risk management strategy is to monitor the effectiveness of responses to emerging situations. This often requires continuous data collection and analysis.


Management of financial risks

There may be different reasons behind the failure of a strategy or trading setup. For example, a trader may lose money when he/she becomes emotional and panic sells, or when the market moves against his/her futures contract position.

Emotional reactions often cause traders to ignore or abandon their initial strategies. This is especially evident during bear markets and periods of capitulation.

Most people in the financial markets agree that having a proper risk management strategy has a significant impact on their success. In practice, doing this can be as easy as placing a Stop-Loss or Take Profit bid.

A solid trading strategy should provide a clear list of possible moves, thus ensuring that traders are better prepared to deal with any situation. But as we mentioned before, there are many different ways to manage risk. Ideally, these strategies should be continually reviewed and adapted.

Below are some examples of financial risks and brief summaries of how to avoid them.

  • Market risk: This risk can be minimized by placing a Stop-Loss order on each trade, thus automatically closing positions before larger losses occur.

  • Liquidity risk This risk can be avoided by trading in high volume markets. Assets with higher market capitalization generally tend to be more liquid.

  • Credit risk: This risk can be reduced by trading through a trusted exchange so that borrowers and lenders (or buyers and sellers) do not have to trust each other.

  • Operational risk: Investors can avoid operational risks by diversifying their portfolios and eliminating risks arising from a single project or company. They can also research to find companies that are less likely to experience operational difficulties.

  • Systemic risk: This risk can also be reduced by portfolio diversification. However, in this case, projects with different proposals or companies from different sectors should be included in diversification. Preferably, those with very low correlations should be chosen.


latest ideas

Traders and investors should consider creating a risk management strategy before opening a trading position or transferring money to a portfolio. However, it is important to remember that financial risks cannot be completely avoided.

Risk management generally determines how risks are managed, but it is certainly not just about avoiding risks. In addition, it includes strategic thinking to manage risks that cannot be avoided in the most effective way.

In other words, it is also about identifying, assessing and monitoring risks, depending on the context and strategy. The risk management process aims to evaluate the risk/reward ratio so that the most profitable positions can be prioritized.