Technical Trading Basics: Risk Management (Types of Risk)

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Welcome back to this Smart Money Club Technical Trading Basics lesson. Now that we know a few basic candlestick patterns, to take your trading to the Power of X you need to know some fundamental aspects of successful trading. One of the most important things is to understand risk management. The idea behind risk management is to reduce the effect of losses. If you walk into a casino and put all your money on red and lose you’ve has a very short trip to the casino. With trading prices will increase and decrease, a key part of successful trading is to manage risk property. Anyone that has been trading for a while will tell you, you will never be right all the time. We want you to be successful, and risk management is one of the keys to success.

Potential

Risk is potential, the potential that the actual return of an investment is lower than its expected return. This can include the potential for loss. When trading with leverage, you can lose more than you’ve put in.  

Risk management is creating a set of rules that ensure the impact of a wrong decision is manageable. Those with effective risk management procedures can even make money when losing more trades than they win because their winning trade’s profits are greater than their losses. We will discuss this later but lets first look at the three types of risk.

Three Types of Risk

Market Risk

This is the most easy to recognize and is the possibility that loss will come due to market movements. There are four factors affecting market prices:

  • Stock prices
  • Interest rates
  • Foreign exchange rates
  • Commodity prices

These factors don’t have to change the prices of the market you are trading directly. If you are trading a stock on the London Stock Exchange and there is a change in the GBP/USD rate, you can lose even if the stock price holds. Any number of elements can have an effect. An Australian copper mining stock can be affected by the copper price, and most commodities are traded in USD, the strength of the dollar will have an effect on commodity prices which affects the mining stock too. Monetary policy changes in China can affect construction to a large degree which changes commodity demands, copper pipes will become more desirable and need to be shipped to China which again affects the mining company stock too. Likewise, a viral outbreak in China can halt construction, and the demand for copper can just as easily fall off.

This all means that it is essential to realize that market risk comes from several sources; some may not be obvious when looking at a potential trade.

Liquidity Risk

Liquidity risk is not as well known as market risk, but it is significant for trading. Liquidity risk is the risk that you are unable to buy or sell an asset quickly enough to prevent suffering a loss. There are two types of liquidity risks.

Asset Liquidity Risk- this refers to an asset’s ability to be traded on a market. Let’s take for example, you buy a penny stock that few people know about and no one wants to buy. You may end up being forced to sell the asset at a less favorable price. Asset Liquidity Risk is generally an issue in an emerging or low volume market.  

Funding Liquidity Risk– this is the risk potential of one of the parties involved in a trade being unable to meet their financial obligations when needed. The time delay that results could have an impact on market prices, or it can cause a trade to fall through entirely.  

Systemic Risk 

The final risk in trading is Systemic Risk; the risk that the financial system around the trade will be affected by one or more events. This kind of risk happened during the global financial crisis of 2008, when subprime debt issues led to the subsequent collapse of major financial institutions like Lehman Brothers, causing stock markets globally to fall. The Covid pandemic and the fall of global markets in March of 2020 is another systemic risk example. 

Systemic Risk’s effects are global, making them hard to protect yourself against; however, those investors with more diverse portfolios tend to be less affected than those who have invested in a single sector or asset type. Other systemic risk examples are natural disasters, geopolitical conflicts (war) and political or regulatory changes. 

In our next Smart Money Club Technical Trading Lesson, we will be continuing with our risk management studies.

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