What is risk and what does it refer to when we talk about trading and investing?
The concept of risk is certainly the most important to consider within the financial markets. It is no coincidence that when we see bear markets they are identified in a "risk-off" phase and when they are bullish they are defined in a "risk-on" phase.
Risk is a key concept with regard to trading and investments because the quality of an operation, the qualities of an investor and a trader are measured precisely on the basis of parameters related to risk. There are different types of risk within the financial markets and some of them are closely linked to the financial instruments and others to the type of trading that the operator carries out. Basically there is a part that establishes the risk, i.e. the markets and the other part that instead has the task of managing the risk which is precisely the investor/trader. In this regard, we clarify the market risks and how a trader/investor can manage them in his operations.
What is the risk
Risk is nothing more than our potential loss on an investment or a general trade. At an operational level, we can define it as that part of the capital destined to be lost if our operation goes wrong; essentially our worst possible outcome. As you can see, we have temporarily linked the concept of risk to something operational, to what can be managed directly by the market operator.
However, the risks managed by the operators are calculated on the basis of certain risk parameters which generally refer to the movements of a particular security or financial instrument. To summarize in a nutshell, a security or financial instrument that tends to move with large market movements is viewed as a risky security. The large and fast movements of a security determine its dangerousness, therefore the securities that have larger movements than others are defined as riskier securities. This concept of risk is therefore linked to the volatility of a security, volatility is therefore an element that indicates how much risk there is to be associated with a specific market or financial instrument. But why are there financial instruments riskier than others? How to manage such volatile and therefore risky instruments?
Risk and liquidity
A volatile market is risky. Why does a market or a financial instrument tend to move more than others, why do they make more volatile movements than others? The answer is found in “liquidity”. Liquidity is a key element in establishing an efficient market, i.e. a market that trades quantities and prices in a healthy way. The more liquid a market is, the healthier it is and the less volatile it will be. A liquid market is essentially a market where there are many operators, a lot of supply and demand for different price levels, therefore many trades on different price levels ensure that the market does not make too fast, sudden and large movements.
Volatility is usually associated with markets that are not very liquid and "small" markets, i.e. markets that do not have many operators inside them. To give a very simple example, Forex is a very large, very liquid market, full of operators of all kinds, from large banks to retail traders, therefore it is a not very volatile market which in fact has movements in very low percentage terms compared to other markets. To give another example, the share market, the risk market par excellence, is a "smaller" market than the currency market, consequently it will have lower liquidity, lower trade value and therefore it will have higher volatility, higher risk than Forex. Warning, this information is of a general nature, there are market moments, especially in the short term where one market can be more volatile than another, real exceptions that could surprise most investors. So in this context, how can I measure volatility? Simple, just measure the average fluctuations in a given period of time.
To give an example if we see that a Forex exchange rate deviates on average by 0.5% per day and a stock makes average daily movements of 1%, we can establish that the exchange rate risk is literally half that of that of the stock. This was obviously a very simplified example but it gives an idea of the risk associated with a certain type of market. To further explore the risk issue, we could go even deeper into each market as, for example, on Forex we find exchange rates that are more liquid than others, the majors, and other exchange rates that are less liquid. The same thing happens within the equity markets where we generally find larger cap stocks that have less volatile movements than smaller cap stocks. In view of the above, the important thing is to have understood that we can associate less risk with greater liquidity and vice versa.
Manage risk
The task of the trader/investor is to manage the risk of his operation and this task determines his long-term success. In practice, the trader’s task is to set a risk for his capital and associate a risk to a specific financial instrument. Once this has been calculated, the trader’s task becomes that of managing the position and consequently managing the risk in an active way so as to preserve the capital for new investments/operations. As can be seen, the trader first associates a risk to his own capital, finds the financial instrument suitable for his risk and then actively manages the risk during the operation.
This is basically the job of the trader/investor, as you can see it is quite different from what is usually seen around where the trader is thought to be a sort of soothsayer of the markets, a sort of seer of the stock markets. The trader manages the risk, this is his job and obviously the ability to read the markets well is a plus that could certainly be very important for the final result, but it is not the essential part. A trader who reads well the market trends without having good risk management, is destined to die in the long run, therefore, given the situation, start focusing more on aspects of this kind which concern the management of one’s own capital and resources in order to then operate on the markets in a conscious and relaxed way.
Original article published on Money.it Italy 2022-12-22 08:57:00. Original title: Trading, cos’è il rischio e a cosa si riferisce negli investimenti
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