Each market-influencing event factor affects the trading volume in terms of position frequency, size, and direction — creating a variance in the speed and intensity of price fluctuations. This is called volatility. Our financial capacity and psychological resilience to endure high volatility determine our risk tolerance.
The higher our risk tolerance is, the higher return potential we will have. In order to understand our risk tolerance and create a plan accordingly, we need to have a risk management plan. The process of managing risks is comprised of three important steps: identification, evaluation, and mitigation. You can find a risk management plan example below.
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Identifying financial risks requires knowledge of the different variables that are in play. Primary economic factors such as interest rate decisions and trade wars usually have a market-wide effect on all industries. Secondary economic factors like economic reports affect the investor and consumer confidence and shift the short- and medium-term trends.
Tertiary economic factors like quarterly earnings reports inform about specific industries or financial assets. Although the range of impact is limited, they can cause massive movements in the target assets. The range of information is wide, but not all of it is relevant to us.
In our trading plan, we should first identify which economic events can affect our assets.
5 Money Management Strategies for Serious Traders
Then, we should note their characteristics in terms of power to fluctuate prices, the frequency they are published, and the factors which can affect the numbers in these reports. Establishing the scope of information to monitor would allow us to eliminate the noise and focus on the relevant news. Next, we should describe the probable scenarios for each report and whether they would have beneficial or adverse effects on our investment. Distinguishing the risky scenarios will allow us to select the related signals in the markets and prepare ourselves for any troubles our portfolio may face.
There are several methods to evaluate different trading risk types. The most common risk evaluation methodologies include management of active risks and passive risks. Active risks refer to the risks arising from the trading strategy employed in the portfolio, and passive risks refer to the risks arising from the exposure of the investment to the market events.
Active risks can be thought as the subjective risk exposure and represent the risks arising from our trading strategy. Alpha is the active risk ratio which measures the performance of an asset against a benchmark in a time period. Using zero as a baseline, a positive alpha indicates higher return percentage than the benchmark, while a negative alpha indicates a lower return.
Passive risks can be thought as objective risk exposure and represent the risks arising from the market events out of our control. Beta is the passive risk ratio which measures the volatility of an asset against a benchmark in a time period.
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Using 1 as a baseline, a beta higher than 1 indicates that the asset price has a higher volatility than the benchmark price, while a beta lower than 1 indicates lower volatility. A higher beta would indicate that investing in this stock would have higher return potential but also higher risk of loss than its benchmark.
A lower beta, on the other hand, would mean lower risk and lower profit potential. We calculate the alpha and beta values from past performances of a financial asset and a benchmark within a time period.
Then, we use this information to predict a similar active and passive risk exposure in an equivalent time period in the future. We analyse the 3-month performance after previous product release to estimate the risk exposure of trading Apple stocks in the next 3 months.
The alpha and beta values of the 3-month period after the previous launch inform us about the active and passive risks in the next three months. There are several ways which we can improve our alpha and beta risk analysis: averaging multiple timeframes, establishing a confidence interval, and using multiple benchmarks. Above example uses only the previous product launch. To improve our estimation, we can use the last three launches.
First, we calculate alpha and beta for each.
Then, we find the averaged alpha and the averaged beta. However, we must consider that each period may have had different market conditions. Analysts often use weighted alpha and weighted beta calculations by assigning weights to each time period with an emphasis on the more recent one. We can improve multiple timeframes by calculating the standard deviation SD of the alpha and the beta values and establish a confidence interval.
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Now that we know how to identify and evaluate active risks that occur due to our trading strategy and the passive risks that occur due to the market conditions, we can use three main approaches to risk mitigation techniques: budget-based approaches, portfolio diversification, and hedging strategies. Budget-based approaches involve money management strategies. According to our resources, leverage and trading goals, we tailor a capital distribution guide which outlines how we use our funds across all investments.
You can also use our trading calculator in order to estimate the possible outcome of a trade before entering it. Position sizing refers to the ratio of a single position size to the total capital. Each asset has different risk factors and volatility levels. Thus, adjusting your position sizing strategy accordingly can establish a balance between the investment and the risk. Knowing when to exit a position is just as important as knowing when to enter it, and it can be emphasised as one of the most fundamental risk control strategies.
Keeping a winning position open to accumulate profits can end up with a market reversal that erases all gains. Similarly, leaving a losing position open, hoping an eventual market reverse, can wipe out the entire capital. Thus, as a forex risk management strategy, when we open a position, we prespecify the price targets and set take profit and stop loss orders to automatically exit the position when they are reached.
Ways to Lower Options Trading Risk
There are several technical indicators to identify price targets:. A correlation can be positive or negative. A positive correlation is when the prices are moving in the same direction; in negative correlation, they move in the opposite direction. Reading this book will enlighten you on the benefits and risks of trading options, as well as the common options trading mistakes to avoid. At the end of this book, readers would have gotten adequate knowledge on how to use popular options strategies. Enter your mobile number or email address below and we'll send you a link to download the free Kindle App.
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Risk Management Techniques for Active Traders
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