What is risk?
Risk is a situation involving exposure to danger. Risk is to expose (someone or something valued) to danger, harm, or loss. – Oxford Languages
In trading risk management is using processes to control, minimize, and protect trading capital from the many dangers in the financial markets. Defining risk parameters is the first step in managing losses in both size and frequency. The primary tools in risk management are position sizing, stop losses, and diversification. The primary reasons that traders are not profitable are due to big losing trades and large drawdowns in trading capital. The first step in mitigating risk is to always keep losses small.
There are many risks that create different ways to lose money in the markets.
A trader’s basic risk is that any individual trade will become a loser. This is trade risk, however a trader can control the maximum amount they lose in most situations through proper position sizing and setting a stop loss.
There is also the general market environment risk factor. You can pick a great stock of a fundamentally strong company but if the trend of the overall stock market itself is down, with equities as an asset class under distribution the odds are that your stock will also go down regardless of the fundamental merits of the company or the past trend of your stock’s price. A bear market is like a strong hurricane that eventually sinks all ships no matter how strong.
The trader has the risk of the price action of their stock becoming highly volatile. Volatility risk can scare a trader into selling their stock too soon or simply cause their system to stop working because the stock that was entered then hit a predetermined stop loss due to an expanded trading range. Volatility can cause a stop loss to be triggered even though it might reverse and return to where it was later that same day.Volatility can cause losses much larger than expected.
Overnight risk happens when a trader holds a position overnight. When something unexpected like news, earnings, or a report happens when the market is closed it can cause a gap in price the next morning when trading reopens. A trader doesn’t have a chance to sell and stop their loss when their market is closed. Overnight risk applies to all traders except day traders who close all positions by the end of the day or traders whose markets are open 24 hours on most days like forex and crypto.
Liquidity risk occurs when there are not many buyers or sellers for your market so a trader loses money in the bid/ask spread. The “bid” price is what a market maker is willing to buy your security at, and the “ask” is what they’re offering to sell it to a trader for. There are stocks and options that have very low volume so a trader could lose 5%-10% just in the process of buying and selling, even if the stock or option price doesn’t move. If a stock has a bid price of $9.50 and an ask price of $10.00 and a trader buys it at the ask price then sells it at the bid price, they lose 5% when they enter and exit the trade. Penny stocks and out-of-the-money options are two markets with the most liquidity risks. It is important to trade in markets that have a small spread in the bid/ask quotes. Less than 10 cents is good but a penny or two is excellent.
Margin risk is when a trader uses stock positions as collateral and borrow money from their broker to buy additional stocks. Most brokers, after you have set up a margin account, will allow a trader or investor to buy additional stocks and double the size of their account buying power. With margin a trader can use a $10,000 account to buy $20,000 worth of stock as long as the stocks are marginable securities. Most penny stocks and many very small cap stocks are not marginable. The powerful thing about margin is a trader can make twice as much profit when they are right on full margin, but the risk is that they can lose twice as much if they’re are wrong. Doubling risk with margin greatly increases the risk of ruin by making losses compound twice as fast. Margin is better used to turn over trading capital versus trading with double the size.
Earnings risk occurs when holding a stock through their earnings announcement, this exposes a trader to the risk of a gap and a sharp move in one direction after the announcement. It can damage a trading account if the move is too fast after hours and moves through the stop loss.
Political risk is the possibility that if you are holding a currency position in forex, invested in a company located in a different country, or your stock’s company does a majority of its business in a country that suddenly has a change in political power. Investors and property owners of all kinds were wiped out when the Communists took over all private property for the state in Cuba in 1960. Also, oil companies lost assets in Venezuela during the communist revolution.
Time decay risk happens when you buy long option contracts, the clock is always ticking against the value of your position. A major component of an options value is its theta time value, each day it loses a small amount of this value. At expiration an option contract is only worth its intrinsic worth of how much it is ‘in-the-money’ based on its strike price. An option trader must understand they must be right about both the price movement and the time frame. An option trader is paying for the right to control the shares, so they have to be right by more than the cost of the option for it to be a winning trade.
There is the risk of error where a trader can put one too many zeroes on the position size they want to buy or sell, or trade the wrong symbol, or sell short instead of buying long. Double checking trades before placing them is very important.
One of the most frustrating types of risk is technology risk. Trading with everything working right is not an easy task but a trader can also have their internet connection go down or their broker’s trading platform quit working while they are in a trade. It is good to have a backup plan like the phone number for your broker in your phone ready to get out of a trade if needed and to have a contingency plan if your internet goes out and you need charts by using an iPad or smartphone. Anything can happen while you are trading, so be prepared for everything.
One of the primary things that will determine a trader’s success is how good they are at risk management.