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Essential steps of the risk management process

risk management

A risk management strategy is a key part of the risk management lifecycle. After identifying risks and assessing the likelihood of them happening, as well as the impact they could have, you will need to decide how to treat them. The approach you decide to take is your risk management strategy. This is also sometimes referred to as risk treatment.

 

Summary of what we are referring to in this article:

What is risk management?
How does risk management work?
Managing financial risks.

 

What is risk management?

In economics, we may describe risk management as the framework that defines how a company or investor handles financial risks, which are inherent to all kinds of businesses.

 

For traders and investors, the framework may include the management of multiple asset classes, such as cryptocurrencies, Forex, commodities, shares, indices, and real estate.

 

There are many types of financial risks, which can be classified in various ways. This article gives an overview of the risk management process. It also presents some strategies that can help traders and investors mitigate financial risks.

 

How does risk management work?

The first step is to define what are the main goals. It is often related to the risk tolerance of the company or individual. In other words, how much risk they are willing to take to move toward their goals.

 

Identifying risks

The second step involves detecting and defining the potential risks. It aims to reveal all sorts of events that may cause negative effects. In the business environment, this step may also provide insightful information that isn’t directly related to financial risks.

 

Risk assessment

After identifying the risks, the next step is to evaluate their expected frequency and severity. The risks are then ranked in order of importance, which facilitates the creation or adoption of an appropriate response.

 

Defining responses

The fourth step consists of defining responses for each type of risk according to their level of importance. It establishes the action to be taken in case an unfortunate event occurs.

 

Monitoring

The final step of a risk management strategy is to monitor its efficiency in response to events. This often requires a continuous collection and analysis of data.

 

Managing financial risks

In financial markets, most people agree that having a proper risk management strategy contributes drastically to their success. In practice, this could be as simple as setting Stop-Loss or Take-Profit orders.

 

A robust trading strategy should provide a clear set of possible actions, meaning that traders can be more prepared to deal with all sorts of situations. As mentioned, though, there are numerous ways of managing risks. 

the 1% trading rule

The 1% trading rule (or 1% risk rule) is a method traders use to limit their losses to a maximum of 1% of their trading capital per trade. This means they can either trade with 1% of their portfolio per trade or with a bigger order with a stop-loss equal to 1% of their portfolio value. The 1% trading rule is commonly used by day traders but can also be adopted by swing traders.

 

While 1% is a general rule of thumb, some traders adjust this value according to other factors, such as account size and individual risk appetite. For instance, someone with a larger account and conservative risk appetite may choose to restrict their risk per trade to an even smaller percentage.

 

Stop-loss and take-profit orders

Stop-loss orders allow traders to limit losses when a trade goes wrong. Take-profit orders ensure that they lock in profits when a trade goes well. Ideally, stop-loss and take-profit prices should be defined before entering a position, and the orders should be set as soon as the trade is open 

Knowing when to cut losses is essential, especially in a volatile market where prices can tumble rapidly. Planning your exit strategy also prevents poor decision-making from emotional trading. The stop-loss and take-profit levels are also essential for calculating the risk-reward ratio of each trade.

 

Recommended reading: What Are Stop-Loss and Take-Profit and why do we have to use them?

 

Diversification

As the old saying goes, you should not put all your eggs in the same basket. In other words, diversify your portfolio. In theory, a well-diversified portfolio offers more protection against massive losses compared to a portfolio made up of only one single asset. If you hold a crypto asset in a diversified portfolio, the maximum damage you would receive if its price tumbles is a percentage of your portfolio. On the contrary, if your portfolio is completely made up of a single asset, then you could potentially lose 100% of your portfolio’s value.

 

Risk-reward ratio

The risk-reward ratio calculates the risk that a trader will be taking relative to the potential reward. To calculate the risk-reward ratio of a trade you’re considering, simply divide the potential loss by the potential profit. So if your stop-loss is at 5% and your target is at 15% profit, your risk-reward ratio would be 1:3, meaning that the potential profit is three times higher than the risk.

 

Recommended reading: 11 Ways for Day Traders to Reduce Stress

 

Closing thoughts

Overall, risk management defines how to handle risks, but it’s certainly not only about avoiding risks completely. It also involves strategic thinking so that the unavoidable risks can be taken in the most efficient way possible.

 

In other words, it’s also about identifying, assessing, and monitoring risks, according to the context and strategy. The process of managing risks aims to evaluate the risk/reward ratio so the most favorable positions can be prioritized.

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