In the context of trading, risk is the potential that your chosen investments may fail to deliver your anticipated outcome. That could mean getting lower returns than expected, or losing your original investment – and in certain forms of trading, it can even mean a loss that exceeds your deposit.
Types of risk
There are two main forms of risk associated with trading: market risk and liquidity risk.
What is market risk?
Market risk is the capacity for your trades to result in losses due to unfavourable price movements that affect the market as a whole. There are several factors that can cause market risk, but movement in any of the following can exert major pressure:
- Stock prices
- Interest rates
- Foreign exchange rates
- Commodity prices
What is liquidity risk?
Liquidity risk is the possibility that you may be forced to trade an asset at a worse price than you anticipated. For example, when trying to sell an illiquid stock you may struggle to find a buyer, meaning that you have to sell your stock for less than its current market value.
In some markets, liquidity risk can even mean that your trade negatively affects the price of the asset you are buying or selling. This is generally more of an issue in emerging or low-volume markets, where there may not be enough people in the market to trade with.
How to manage your risk
Risk management is the process of identifying, analysing and reducing risk in your trading decisions. Usually, it involves developing a trading plan that helps you decide what to trade, when to trade and where to place your stop losses. Here are three tips on how to manage risk:
1. Assess risk vs return
In general, trading strategies focus on weighing up a trade’s potential risk against its potential return. If a trade has greater risk, it should carry the chance of a greater return to make that risk worthwhile.
For example, government bonds are considered a safe, low-risk investment – but when compared to corporate bonds, they offer lower rates of return. This is because the risk of investing in a corporate bond is higher, so to compensate for the added risk investors are offered a higher rate of return.
2. Understand each market’s risks
It’s important to ensure you understand the factors that influence different markets, so you can base your dealing strategies on relevant information. Improve your success rate by learning more about the markets you’re dealing on and exploring new strategies.
Our trading skills section is a great place to learn about all the markets we offer.
3. Keep learning
Learning to trade successfully while managing your risk is a continual process – and one of the best ways of ensuring that you are always improving is by starting a trading diary. By keeping track of which trades and strategies have worked in the past, you can build on your successes and learn from your failures.