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Trading Risks

Trading is the same as operating a small business – to survive you must manage all aspects of your business to ensure long-term sustainability. An important aspect of trading often neglected is risk management.

Risk management involves setting rules and guidelines to keep your risk at a level that you are comfortable with. Risk in a trading sense refers to the possibility of losing money in the market place (i.e. market exposure). The main factors affecting this are listed below:

  • Trade position size
  • Stop loss size
  • Market tracking abilities
  • Volatility of shares

If we are able to control the above factors, then we can control risk. When developing a trading system, these should be at the forefront of your mind. The first step in risk management is to identify the risks involved in your trading activity and devise a strategy for alleviating these risks where possible or managing them when not.

Although this website does not provide personal financial product advice, you should be aware of the main risks associated with investing in listed equity securities. Some of these risks are outlined below.

  • Overall market risk – This is the risk of loss by reasons of movements in a market sector, such as changes in interest rates, political changes, changes in superannuation laws, or internal crises. Market risk can be minimised by having a spread of investments across different types of assets.
  • Global risk – This is the vulnerability of an investment to international events or market factors. This would include movements in exchange rates, changes in trade or tariff policies and changes in international or bond markets.
  • Sector risk – The risks associated with an industry’s specific products or services such as demand for the product or service, commodity prices or the economic and industry cycles. This may be minimised by detailed research to identify quality investments, reviewing their performance and their place in a portfolio.
  • Equity specific asset risk – risks associated with the specific investment. For example, the strength of management and key personnel; profitability and asset base; debt level and fixed-cost structure; competition levels or liquidity of the investment.
  • Timing risk – The possibility that you enter the market at a bad time, for example just before a fall in the share market. This can be minimised by not investing all of your funds into the market at one time.
  • Speculative risk – If an investment is described as speculative, you should be aware that the investment could rise significantly but also fall by the same degree. You should not invest in speculative investments unless you are prepared to accept any resultant loss.

It should be noted that risk is an inevitable part of trading, so investors should always attempt to mitigate those risks, but if you are not willing to take on any then leave your money in the bank (and even that isn’t an iron-clad guarantee!).

Risk and money management is there to handle the inevitable trades that have not gone in the desired direction, and used properly should allow you to continue trading even after several losses.

A profit or loss on a trade is the result of the direction and extent of a price move, multiplied by the number of shares that you own.

You cannot control the direction of a market, or the extent of a price move but you can control your position size (i.e. the number of shares that you own). Your ability to do this is going to directly affect your profitability as a trader. A profitable trader is one who has the ability to manage their losing trades.

Tailoring Risk Management to your Personal Circumstances

As part of risk management any participation in the share market should be tailored to your own personal situation.

  • Financial position and risk tolerance – If your trading float is borrowed money, your tolerance for risk would probably be very low and a conservative trading style may be more appropriate. On the other hand, if your trading float represented only 2% of your net worth, your tolerance for risk may be much higher.
  • Time availability – an aggressive trading system may require a trade to be placed almost every day, and trailing/profit exits to be moved regularly. A less aggressive trading style may involve taking a trade on average every two weeks with less effort required in monitoring trailing profit stops.
  • Experience – although time plays a part in gaining experience, exposure is the major factor. Reading books associating with successful traders and paper trading all offer ways of fast-tracking your experience level.
  • Personality – it is important to select a trading style that will mesh with your personality. You may find you want to change your trading style once you have gained some trading experience.

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